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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
Form 10-K
(Mark One)
[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the fiscal year ended March 31, 2000
OR
[_] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission file number: 0-24507
PILOT NETWORK SERVICES, INC.
(Exact name of registrant as specified in its charter)
Delaware 94-3305774
(State or other jurisdiction of (I.R.S. Employer Identification No.)
incorporation or organization)
1080 MARINA VILLAGE PARKWAY
ALAMEDA, CA 94501
(Address of principal executive offices, including zip code)
Registrant's telephone number, including area code: (510) 433-7800
Securities registered pursuant to Section 12(b) of the Act: None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, par value $0.001
Indicate by check mark whether the registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter period than the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. YES [X] NO [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of the
registrant was approximately $129.8 million as of June 1, 2000, based upon the
closing sale price on the Nasdaq National Market reported for such date.
Shares of Common Stock held by each officer and director and by each person
who owns 10% or more of the outstanding Common Stock have been excluded in
that such persons may be deemed to be affiliates. This determination of
affiliate status is not necessarily a conclusive determination for other
purposes.
There were 15,078,365 shares of the registrant's Common Stock issued and
outstanding as of May 31, 2000.
DOCUMENTS INCORPORATED BY REFERENCE
Part III incorporates information by reference from the definitive proxy
statement for the Annual Meeting of Stockholders to be held on September 14,
2000.
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Forward Looking Statements
In addition to historical information, this Annual Report contains forward-
looking statements. These forward-looking statements are subject to certain
risks and uncertainties that could cause actual results to differ materially
from those reflected in these forward-looking statements. Factors that might
cause such a difference include, but are not limited to, those discussed in
the section entitled "Management's Discussion and Analysis of Financial
Condition and Results of Operations--Factors That May Affect Future Results
and Market Price of Stock." Readers are cautioned not to place undue reliance
on these forward-looking statements, which reflect management's opinions only
as of the date hereof. The Company undertakes no obligation to revise or
publicly release the results of any revision to these forward-looking
statements. Readers should carefully review the risk factors described in
other documents the Company files from time to time with the Securities and
Exchange Commission, including the Quarterly Reports on Form 10-Q to be filed
by the Company in fiscal year 2001.
PART I
Item 1. Business.
Overview
Pilot Network Services, Inc. (the "Company" or "Pilot") provides a wide
range of secure Internet services that incorporate high-bandwidth connectivity
and enable secure electronic business over the Internet. The services are
offered for a fixed monthly fee on an annual subscription-basis. The Company's
services include secure hosting and Internet connectivity services that enable
secure connectivity between a corporate network and the Internet and secure
virtual private networking services that enable remote users and wide-area
networks to securely communicate enterprise-wide and over the Internet. The
Company offers a scalable solution that allows customers to quickly deploy and
expand electronic business capabilities by subscribing to Pilot's secure
Internet services.
Pilot's subscription-based secure Internet services allow customers to avoid
the risks associated with traditional approaches to Internet security.
Customers can also avoid extensive costs associated with implementing an in-
house solution, including set-up costs for security and systems design,
hardware, software, Internet access services provided by Internet Service
Providers ("ISPs") and labor, and ongoing costs for telecommunications,
staffing, maintenance and upgrades.
The foundation of Pilot's solution is its Heuristic Defense Infrastructure,
an Internet security approach developed by Pilot to continuously manage and
monitor Internet traffic to and from customer networks in order to respond in
real-time to security threats. The Heuristic Defense Infrastructure consists
of a multi-layered defensive architecture and around-the-clock security
operations delivered through geographically dispersed Pilot customer centers
called Network Security Centers that are connected to customer networks via
dedicated, high-speed data lines. The Pilot solution aggregates the experience
gained from protecting each customer against attacks and leverages such
experience for the collective benefit of all customers. The Heuristic Defense
Infrastructure offers benefits over other security approaches by eliminating
single points of failure, enhancing attack detection, delivering real-time
defenses, and adapting continuously to external conditions. Customers can
concentrate on their core business because the secure infrastructure for
electronic commerce is provided by Pilot.
The Company was incorporated in California on August 6, 1992 and was
reincorporated in Delaware on August 4, 1998. Unless the context otherwise
requires, the term "Company" or "Pilot" refers to Pilot Network Services,
Inc., a Delaware corporation, and its California predecessor. The Company
maintains its executive offices and principal facilities at 1080 Marina
Village Parkway, Alameda, CA 94501. Its telephone number is (510) 433-7800.
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Industry Background
Internet connectivity has increased and businesses have become more
comfortable with the ease-of-use and reliability of on-line commerce, often
termed e-business. In the current competitive environment, e-business has
emerged as a corporate requirement. The volume of on-line business-to-business
transactions is expected to grow. Forrester Research predicts that the value
of goods bought and sold in on-line business-to-business transactions will
greatly expand from an estimated $109 billion in 1999, rising to $1.3 trillion
by 2003. Additionally, business-to business services conducted via the
Internet are expected to grow from $22 billion in 1999 to $220 billion in
2001, resulting in a total business-to-business electronic commerce market
size of $1.5 trillion in 2003.
A convergence is underway between the public network and the corporate back-
office as a result of the move to a global digital economy. This has resulted
in legacy information-technology ("IT") systems becoming increasingly network-
centric. Rather than deploy and manage their own private networks, companies
would like to use the publicly available Internet. The use of new and existing
IT systems over the Internet is causing growing concern about security. The
security concern is intensified as companies make plans to exchange sensitive
business information with their customers and partners over the unrestricted
Internet medium.
Fortune 500 companies are looking more and more to outsource their business
operations as complexity increases and IT resources remain scarce. It is
expensive for medium and large companies to build security expertise within
their IT organizations while smaller businesses simply lack the means and
resources to implement adequate security measures for their networks.
Gartner Group estimates that by 2003, 80% of enterprises will use the
Internet for telecommuting access for mobile users and communications with
trading partners. By 2004, more than 50% of enterprises will use the Internet
for 80% of their external procurement activities. All of these activities are
changing enterprise security requirements as internal business systems are
made available to external sources.
The Pilot Solution
Pilot offers services designed to combine the highest level of commercially
available security with high bandwidth connectivity to enable secure
electronic commerce over the Internet. The foundation of Pilot's solution is
its Heuristic Defense Infrastructure, consisting of a multi-layered defensive
architecture and security operations 24 hours a day, 7 days a week (24x7)
delivered through geographically dispersed Network Security Centers. This
infrastructure allows Pilot to continuously manage and monitor Internet
traffic to and from customer networks in order to respond in real-time to
security threats. The Pilot solution aggregates the experience gained from
protecting each customer against attacks and leverages such experience for the
collective benefit of all customers. The Heuristic Defense Infrastructure
offers benefits over other security approaches by eliminating single points of
failure, enhancing attack detection, delivering real-time defenses, and
adapting continuously to external conditions.
The Company provides a wide range of secure network services for a fixed
monthly fee on an annual subscription-basis. The Company's services include
secure hosting and Internet connectivity services that enable secure
connectivity between a corporate network and the Internet and secure virtual
private networking services that enable remote users and wide-area networks to
securely communicate over the Internet with a local network. The Company
offers a scalable solution that enables customers to quickly deploy and expand
electronic commerce capabilities by subscribing to Pilot's secure Internet
services. As a result, companies avoid costs associated with implementing an
in-house solution, including set-up costs for security and systems design,
hardware, software, ISP services and labor, and ongoing costs for
telecommunications, staffing, maintenance and upgrades. Pilot's services
enable customers to concentrate on their core business because the secure
infrastructure for electronic commerce is provided by Pilot. The Company's
strategy is to become the leading supplier of secure electronic business
services for companies worldwide.
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Key elements of the Company's strategy include:
Services
The Company offers two primary categories of services: secure hosting and
Internet connectivity services and secure virtual private networking services.
Customers subscribe to the Company's services for an initial installation fee
and a fixed monthly fee. The Company's contracts with its customers are
generally based on a one-year term with renewal periods. Service fees vary
according to the services selected by the customer. The minimum first-year
commitment consists of an installation fee of $13,500 followed by a recurring
fee of $6,500 per month upon the completed installation of the services.
Secure Hosting and Internet Connectivity Services. The Company provides
secure access services that enable secure connectivity between a corporate
network and the Internet. Services range from access to electronic mail
gateways and Web servers to securing electronic businesses. Secure hosting and
electronic business services integrate high-throughput data transmission
(10Mbps and higher) with around-the-clock host and network security.
Secure Virtual Private Networking Services. The Company provides secure
virtual private networking services that combine security and bandwidth to
enable remote users and wide-area networks to communicate securely enterprise-
wide and over the Internet. These services include encryption, authentication
and access control technologies to protect both the information in transit as
well as the security of the network.
See "Item 7--Risks Associated with the Emerging Market for Outsourced
Network Security Services."
Pilot Heuristic Defense Infrastructure
The Pilot Heuristic Defense Infrastructure consists of a multi-layered
defensive architecture that learns from experience and 24x7 security
operations provided through geographically dispersed Network Security Centers.
Proprietary Architecture
Proprietary Security Processes. The Company has developed a set of patent-
pending technology-based processes, including secure networking, a layered
defense, real-time data collection and analysis, and a feedback loop that
continuously updates a database of security threats and responses. ISPs
typically permit all traffic that is not explicitly restricted, while Pilot's
secure network blocks all traffic that is not explicitly permitted, greatly
reducing the risk of an attack. Legitimate inbound traffic from the Internet
passes through a number of increasingly protective defensive layers on its way
to a customer. Each layer provides a different type of protection, and
combined with customer-specific security policies creates a secure environment
for electronic business transactions and networks. The layered defense enables
the Company to detect, analyze, plan and defend, thereby reducing the
probability of and minimizing the potential damage from an attack. Data
collection and analysis processes include security logging, monitoring and
analysis and authentication. The data from these processes is then analyzed by
proprietary software that applies policy rules and statistical analysis to
identify patterns which could signal an attack in progress. This data along
with ongoing research into current attack methods is continuously used to
update the Company's defense databases and processes, resulting in a system
that learns from its experiences and adapts defenses to respond to emerging
attack techniques. This process allows the Company to aggregate the experience
gained from protecting each individual customer and leverage such experience
for the collective benefit of all customers.
Multi-Layered, Distributed Architecture. Pilot's multi-layered defense
distributes specific functions across separate devices. This adds isolation,
in which the breach of one device does not compromise another; detectability,
in which the time required to attack (and the time available to detect an
attack) is increased; and performance, in which the performance and
measurability of each device can be tailored for its particular purpose. In
contrast, a traditional firewall software package requires many services, such
as electronic mail, telnet, DNS, and FTP, to pass through a single device.
This complexity makes it difficult to rule out inadvertent
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interactions between one type of service and another within the same device.
Pilot's distributed defense eliminates these interactions and simplifies
attack detection by distributing each function across separate devices. In
addition, the Company continuously evaluates new technologies to ensure that
it incorporates best-of-breed hardware and software into its infrastructure.
Security Operations, Investigation and Development
Trained Security Personnel. Pilot's security team includes expert engineers
with significant security experience. The Security Team consists of three
groups: (i) Security Operations, which handles the day-to-day management of
the Pilot Heuristic Defense Infrastructure, manages incident investigation and
response, and applies standard procedures regarding changes to Pilot's systems
and services, (ii) Security Investigation, which is responsible for incident
analysis and escalation, attack pattern research, defense design, and service
extension, (iii) Security Development, which is responsible for the creation
of new automated methodologies, the acquisition and maintenance of security
tools and the development of internal tools, advanced research and development
as well as defining new services that may be introduced to customers.
Dynamic 24x7 Monitoring and Management. The Pilot Heuristic Defense
Infrastructure provides a flexible, dynamic and rapid response capability, 24
hours per day, seven days per week, through its Security Team and the
monitoring and management methods described below. All systems within the
Pilot Heuristic Defense Infrastructure log their status and activities in
detail. Using advanced display and analysis tools developed by Pilot, the
Security Team detects and stores patterns indicative of an attack and blocks
attackers from further attempts. Patterns of attack attempts are collected in
a centralized security database. Pilot's monitoring and management methods
allow it to protect customers by blocking new attacks on a real-time basis and
rapidly adapting and automating its security defenses.
Third-Party Audits. Pilot regularly engages independent third-party security
experts to audit its Heuristic Defense Infrastructure. Such auditors prepare a
detailed technical report for Pilot's internal use, and an executive summary
available to Pilot's current and potential customers. The most recent audit
was completed by Trident Data Systems in September 1999.
Network Infrastructure
Network Security Centers. The Company provides its services to customers by
connecting their networks to the Internet through its regional Network
Security Centers via dedicated, high-speed data lines. The Company currently
has major Network Security Centers located in the San Francisco, Los Angeles,
New York and Chicago metropolitan areas, with smaller Network Security Centers
in the Boston, Washington D.C. and London metropolitan areas. Each Network
Security Center establishes interconnections with other global and local
Internet service providers. The Company currently connects directly to the
Internet at four major network access points: Pacific Bell and Palo Alto
Exchanges in Northern California; Sprint in New York; Ameritech in Chicago;
and the London Internet Exchange (LINX) in London. Additionally, Pilot
benefits from approximately 64 private Internet peering agreements. (A
"peering" agreement allows private Internet carriers to provide mutually
beneficial Internet traffic balancing with each other.) The Company also
maintains private connections from each Network Security Center to Cable and
Wireless, Sprint and UUNET. Each Network Security Center is also connected to
Pilot's Secure Asynchronous Transfer Mode (ATM) Backbone. As a result,
customer connectivity to various Internet sites can be improved by routing
traffic through Pilot's Secure ATM Backbone in addition to direct Internet
interconnections.
The distributed design of the Company's secure network infrastructure allows
Pilot to scale security and electronic business services differently than
other industry providers. Additional servers, telecommunications capacity and
Pilot services can easily be added to meet customer demand. In the event of
equipment failure, operations are disrupted only for the components involved,
and not across all services. Because of Pilot's standardized operations,
internal monitoring and backup equipment, a failure can be detected and a
replacement
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operation scheduled rapidly, minimizing downtime. Each Network Security Center
is staffed by technical, sales and customer support personnel, and operates as
a physically secured facility for Pilot and customer equipment.
Pilot Secure ATM Backbone. In addition to bandwidth management, the Pilot
Secure ATM Backbone is used for Pilot-specific traffic, such as security
management and monitoring, and customer-specific traffic, such as secured
traffic between multiple Pilot customers. Unlike backbone networks of most
other providers, this network blocks all traffic except for traffic that is
specifically allowed. The Pilot Secure ATM Backbone also supports a wide
variety of encryption options, so that traffic between customers can be
secured at multiple levels.
The operation and expansion of the Company's secure network infrastructure
is subject to a number of risks, including those set forth in "Item 7--Risks
Associated with Security Breaches," "--Risks of Business Expansion and
Management Growth," "--Risks of System Failure," "--Dependence Upon
Scalability of the Company's Network" and "--Dependence on Third-Party Network
Infrastructure Providers."
Third-Party Delivery of Heuristic Defense Infrastructure
Pilot plans to increase its global presence by having telecommunication
carriers deliver Pilot Protected secure connectivity, hosting and extranet
services. Carriers will provide these e-business services through their
centers to their clients and will bear the costs of implementation and on-
going operations. Pilot will provide around-the-clock, built-in security
through its invention, the Heuristic Defense Infrastructure, which will be
embedded in carrier operations centers and monitored as a global Pilot
service. This business model is innovative in that it combines annuity revenue
streams with a software-industry gross margin opportunity, since many of the
capital and operating expenses are borne by the telecommunications partner.
In these third-party agreements, Pilot sells technologies and methodologies
to the telecommunications carrier. The telecommunications carrier builds its
operation center(s) to embed Pilot's Heuristic Defense Infrastructure. The
carrier may also hire Pilot to provide consulting services in conjunction with
the build-out. When the center is operational, the carrier pays Pilot a
recurring fee based on the total revenue generated through the Heuristic
Defense Infrastructure. In exchange, Pilot provides around-the-clock security
monitoring for network traffic using the Heuristic Defense Infrastructure.
In fiscal 2000, Pilot reached agreement with two telecommunications carriers
to provide third-party delivery of Pilot's Heuristic Defense Infrastructure.
At March 31, 2000, no centers were operational.
Customers
The Company's customers span a diverse range of industries including
financial and professional services, high technology, industrial and
manufacturing, consumer, entertainment, education and media. The Company's
services are suitable for any organization building or maintaining Internet-
based connectivity for their networks or applications at or above the
Company's minimum bandwidth requirements. No single customer accounted for
more than 10% of the Company's total revenues for the year ended March 31,
2000.
Sales and Marketing
The Company's sales and marketing efforts are designed to achieve broad
market penetration by targeting enterprises that depend upon the Internet for
electronic commerce and business communications. The Company also builds its
recurring revenue base from such enterprises by continuing to provide value-
added services and through active customer account management.
As of March 31, 2000, the Company had 64 employees in sales and marketing.
The Company's sales force is organized into separate groups consisting of
field sales (new customers), customer account management (customer retention
and expansion), alliances (channel and OEM sales), strategic accounts and pre-
sales engineering support. Each of these groups is further divided into
geographical regions. The Company's sales staff
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is primarily located in the San Francisco, Los Angeles, New York, Chicago,
Washington D.C., Boston and London metropolitan areas.
To date, most of the Company's sales have been derived directly through the
efforts of its sales force. The Company is actively seeking to increase its
sales and marketing capabilities and coverage in the United States and to
expand internationally as new Network Security Centers are established outside
of the United States. See "Item 7--Risks of Business Expansion and Management
of Growth."
A key element of the Company's sales and marketing strategy is to strengthen
relationships with partners in order to generate an increasing percentage of
total sales through partners. In fiscal 2000, Pilot reached agreement with two
telecommunications carriers to configure several of their security centers to
deliver Pilot's Heuristic Defense Infrastructure. This will provide Pilot with
faster, less expensive access to established customer bases and geographic
reach. Additionally, the Company is building joint-marketing relationships
with strategic partners, such as Arthur Andersen LLP, electronic commerce
vendors, such as BroadVision, Open Market and VeriSign, technology vendors,
such as Cisco Systems, Inc., Sun Microsystems, VPNet Technologies, IPass, and
TrendMicro and selected telecommunications partners. See "Item 7--Risks
Associated with Third Party Delivery of Heuristic Defense Infrastructure" and
"--Dependence on Other Third-Party Relationships."
The Company's marketing organization is responsible for new service
introductions, public relations and marketing communications. New service
introductions include strategy, definition, pricing, competitive analysis,
launches, and partner program management. The Company stimulates demand for
its services through a broad range of marketing communications and public
relations activities, including co-marketing programs with the Company's
marketing partners. Primary marketing communications vehicles include Web
banner and direct mail promotions, telemarketing, trade shows and seminars,
event sponsorship and management of the Company's Web site. Public relations
focuses on cultivating industry analyst and media relationships with the goal
of obtaining media coverage and public recognition of the Company's leadership
position in the market for secure electronic commerce and business
communications services.
The Company regularly conducts account reviews internally with customers to
measure satisfaction. Pilot's customer base provides revenue growth
opportunities in the form of referrals, recurring revenue, and new services.
Customers generally enter into one-year agreements with the Company, with
renewal periods. However, there can be no assurance that the Company's
customers will continue or renew their commitments to use the Company's
services.
Competition
The market served by the Company is new, rapidly evolving, highly
competitive and largely undefined. There are few general barriers to entry,
and the Company expects that it will face additional competition from existing
competitors and new market entrants in the future. The Company believes that
this market is characterized by a limited period of time during which
participants must grow rapidly and achieve a significant presence in the
market in order to compete effectively. The Company also believes its
Heuristic Defense Infrastructure provides the Company with a competitive
advantage in the marketplace. The principal competitive factors in this market
include Internet services and security engineering expertise, customer
service, network and security capabilities, reliability, quality and
scalability of service, broad geographic presence, brand name, technical
expertise and functionality, the variety of services offered, the ability to
maintain and expand distribution channels, customer support, price, the timing
of introductions of new services, financial resources and conformity with
industry standards. There can be no assurance that the Company will have the
resources or expertise to compete successfully in the future.
The Company competes with a broad range of products and services. The
Company's competitors include companies providing security, electronic
commerce, and secure Internet networking products that are offered as stand-
alone product solutions. Companies offering stand-alone software products
include providers of firewall software, such as Check Point Software
Technologies and AXENT Technologies (formerly Raptor Systems),
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security monitoring software, such as ISS Group, and electronic commerce
products. The security and electronic commerce products provided by these
companies are typically implemented and managed by internal MIS departments of
enterprises. In addition, internal corporate MIS departments increasingly rely
on third party consultants or system integrators to manage the integration and
implementation of multiple stand-alone products from different vendors.
The Company also competes with third party service providers that offer
Internet hosting and access services, including (i) providers of server
hosting services, such as Exodus Communications and PSI Net; (ii) national and
regional ISPs such as Concentric Network Corp., UUNET (part of MCI WorldCom),
certain subsidiaries of GTE Corporation and Global Center, which was acquired
by Frontier Corporation; and (iii) global, regional and local
telecommunications companies such as Sprint and MCI WorldCom, and regional
bell operating companies. The Company also competes with information
technology service firms providing either outsourcing or systems integration
services such as International Business Machines Corporation and Electronic
Data Systems. Although these third party service providers often add security
features to their service offerings, either through internal development
efforts or through the incorporation of products purchased from vendors of
stand-alone point solutions, the Company believes that generally these
competitors do not offer the same level of security in their services as the
Company. However, the Company expects perceived competition to intensify as
third party service providers incorporate a broader range of security,
electronic commerce and secure Internet networking services and products into
their service offerings. Furthermore, the Company may face competition from
its vendors and other partners. The Company's agreements with its vendors and
other partners generally do not limit or restrict those parties from selling
similar products and services directly to the Company's customers or its
competitors, thereby enabling such parties to compete against the Company.
There can be no assurance that such vendors or other partners will not compete
with the Company in the future.
Many of the Company's competitors have substantially greater financial,
technical and marketing resources, larger customer bases, longer operating
histories, greater name recognition and more established relationships in the
industry than the Company. As a result, certain of these competitors may be
able to develop and expand their network infrastructures and service offerings
more quickly, adapt to new or emerging technologies and changes in customer
requirements more quickly, take advantage of acquisition and other
opportunities more readily, devote greater resources to the marketing and sale
of their products and adopt more aggressive pricing policies than the Company.
In addition, these competitors have entered, and will likely continue to
enter, into joint ventures or consortiums to provide additional services
competitive with those provided by the Company. Certain of the Company's
competitors may be able to provide customers with additional benefits in
connection with their Internet system and network management solutions,
including reduced communications costs, which could reduce the overall costs
of their services relative to the Company's. There can be no assurance that
the Company will be able to offset the effects of any resulting price
reductions. In addition, the Company believes that the businesses in which the
Company competes are likely to encounter consolidation in the near future,
which could result in increased price and other competition that could have a
material adverse effect on the Company's business, results of operations and
financial condition.
Intellectual Property Rights
The Company relies on a combination of copyright, trademark, service mark
and trade secret laws and contractual restrictions to establish and protect
certain proprietary rights in technology underlying its services. The Company
has applied for three separate patents in the U.S. and Europe and intends to
continue to seek patents on its inventions when appropriate, although the
Company currently has no patented technology that would preclude or inhibit
competitors from entering the Company's market. There can be no assurance that
patents will issue from currently pending or any future applications, or that
any patents that may be issued will be sufficient in scope or strength to
provide meaningful protection or any commercial advantage to the Company. The
Company has three separate trademarks registered with the United States Patent
and Trademark Office, including the Pilot name and its distinctive Pilot logo.
Additionally, the Company has registered the Pilot name in three foreign
jurisdictions. The Company has seven separate trademark applications pending
in the United
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States and counterparts in certain foreign jurisdictions for distinct marks.
However, there can be no assurance that such trademarks will be granted. The
laws of certain foreign countries may not protect the Company's products,
services or intellectual property rights to the same extent as do the laws of
the United States.
The Company has entered into confidentiality and invention assignment
agreements with its employees and contractors, and nondisclosure agreements
with its suppliers, distributors and appropriate customers in order to limit
access to and disclosure of its proprietary information. There can be no
assurance that these contractual arrangements or the other steps taken by the
Company to protect its intellectual property will prove sufficient to prevent
infringement of or misappropriation of the Company's technology or to deter
independent third-party development of similar technologies. Any such
infringement or misappropriation, should it occur, could have a material
adverse effect on the Company's business, results of operations and financial
condition. Furthermore, litigation may be necessary to enforce the Company's
intellectual property rights, to protect the Company's trade secrets, to
determine the validity and scope of the proprietary rights of others, or to
defend against claims of infringement or invalidity. Such litigation could
result in substantial costs and diversion of resources and could have a
material adverse effect on the Company's business, results of operations and
financial condition.
To date, the Company has not been notified that the Company's services
infringe the proprietary rights of third parties, but there can be no
assurance that third parties will not claim infringement or indemnification by
the Company with respect to current or future services. The Company expects
that participants in its markets will be increasingly subject to infringement
claims as the number of products and competitors in the Company's industry
segment grows. Any such claim, whether meritorious or not, could be time-
consuming, result in costly litigation, cause product installation delays,
prevent the Company from using important technologies or methods, subject the
Company to substantial damages, or require the Company to enter into royalty
or licensing agreements. Such royalty or licensing agreements may not be
available on terms acceptable to the Company or at all. As a result, any such
claim could have a material adverse effect upon the Company's business,
results of operations and financial condition.
Government Regulation and Legal Uncertainties
There is currently only a small body of laws and regulations directly
applicable to access to or commerce on the Internet, other than regulations
applicable to businesses generally and regulations applicable to certain
encryption technologies incorporated into products provided by certain of the
Company's vendors. However, because the Internet has recently emerged, there
is significant uncertainty as to the application of existing laws and
regulations with respect to the Internet, covering issues such as user
privacy, freedom of expression, pricing, characteristics and quality of
products and services, taxation, advertising, intellectual property rights,
information security and the convergence of traditional telecommunications
services with Internet communications. Moreover, a number of laws and
regulations have been proposed and are currently being considered by federal,
state and foreign legislatures with respect to such issues. The nature of any
new laws and regulations and the manner in which existing and new laws and
regulations may be interpreted and enforced cannot be fully determined.
Therefore, such laws and regulations could decrease the growth of the
Internet, decrease demand for the Company's services, restrict the Company's
activities, impose taxes or other costly technical requirements, subject the
Company and/or its customers to potential liability or otherwise adversely
affect the Company or its customers, each of which could have a material
adverse effect on the Company's business, results of operations and financial
condition. For example, because the Company's services are available over the
Internet in multiple states and foreign countries, and as the Company
facilitates sales by its customers to end users located in such states and
foreign countries, such jurisdictions may claim that the Company is required
to qualify to do business as a foreign corporation in each such state or
foreign country, which could have a material adverse effect on the Company's
business, results of operations and financial condition.
A number of governments have imposed controls, export license requirements
and restrictions on the export of encryption technologies provided by certain
of the Company's vendors. To the extent the Company or its vendors are
required to export products incorporating certain encryption technology
developed in the United States in support of services provided to the
Company's customers located outside of the United States, the
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Company and its vendors will need to comply with United States export
controls. In particular, all cryptographic products require either
qualification under appropriate licensing exemptions or export licenses from
either the U.S. State Department, acting under the authority of the
International Traffic in Arms Regulation, or the U.S. Commerce Department,
acting under the authority of the Export Administration Regulations.
Furthermore, if the Company is unable to comply with such export controls, it
may not be able to obtain on commercially reasonable terms encryption
technologies developed outside the United States for its international
services that provide for encryption as strong as those developed in the
United States. There can be no assurance that U.S. export restrictions will be
changed to allow stronger encryption for international delivery, that the
Company or its vendors will be able to comply with such restrictions, or that
such factors will not have a material adverse effect on the Company's
business, operating results and financial condition.
Employees
As of March 31, 2000, the Company had 216 full-time employees, including 100
people in security implementation, customer support and operations, 34 people
in security engineering, 64 people in sales, marketing, customer account
management and pre-sales engineering support and 18 people in finance and
administration. The Company's success depends to a significant degree upon the
continued contribution of its executive management and security operations and
engineering teams. See "Item 7--Dependence on Key Personnel" and "--Risks of
Business Expansion and Management of Growth."
Item 2. Properties.
Facilities
The Company's executive, sales and administrative offices are located in
Alameda, California. The Company has major Network Security Centers located in
the San Francisco, Los Angeles, New York and Chicago metropolitan areas
covering an aggregate of approximately 54,850 square feet under leases that
expire between October 2002 and February 2009. The Company has satellite
Network Security Centers in the Washington D.C., Boston and London
metropolitan areas. The Company's leases for its executive, sales and
administrative offices and its satellite Network Security Centers expire at
various times through September 2004 (excluding options to renew), and cover
an aggregate of approximately 24,000 gross square feet.
Most of the Company's leases provide for a renewal option upon the
expiration of the initial term. The Company believes that these existing
facilities are adequate to meet its current foreseeable requirements or that
suitable additional or substitute space will be available on commercially
reasonable terms. Pilot plans to expand its Network Security Centers both
nationally and internationally.
Item 3. Legal Proceedings.
The Company is currently not a party to any material legal proceedings.
Item 4. Submission of Matters to a Vote of Security Holders.
Not applicable.
10
<PAGE>
PART II
Item 5. Market for Registrant's Common Equity and Related Stockholder Matters.
The Company's Common Stock has been traded on the NASDAQ National Market
since the Company's initial public offering in August of 1998. According to
records of the Company's transfer agent, the Company had approximately 82
stockholders of record as of March 31, 2000. Because many of such shares are
held by brokers and other institutions on behalf of stockholders, the Company
is unable to estimate the total number of stockholders represented by these
record holders. The following table sets forth the low and high sale price as
of the close of the market for the Company's common stock in each of the
Company's last seven fiscal quarters:
<TABLE>
<CAPTION>
Low Closing Price High Closing Price
----------------- ------------------
<S> <C> <C>
Fiscal 2000:
Fourth Quarter...................... $22.750 $50.375
Third Quarter....................... 9.875 24.000
Second Quarter...................... 7.125 12.313
First Quarter....................... 8.688 20.063
Fiscal 1999:
Fourth Quarter...................... 8.063 15.500
Third Quarter....................... 4.000 9.500
Second Quarter (August 10--September
30)................................ 4.625 14.500
</TABLE>
The Company has not yet made any earnings and intends to reinvest any
possible future earnings to fund future growth. Accordingly, the Company has
not paid dividends and does not anticipate declaring dividends on its
indicated. No payments were made to directors or officers of the Company or
their associates, holders of 10% or more of any class of equity securities of
the Company or to affiliates of the Company, other than compensation paid in
the ordinary course of business.
11
<PAGE>
Item 6. Selected Financial Data.
The selected financial data set forth below should be read in conjunction
with "Management's Discussion and Analysis of Financial Condition and Results
of Operations," the consolidated financial statements and the notes thereto
and the other information contained in this Form 10-K. The selected statement
of operations data for the years ended March 31, 1998, 1999 and 2000, and the
selected balance sheet data as of March 31, 1999 and 2000, are derived from,
and are qualified by reference to, the audited financial statements of the
Company appearing elsewhere in this Form 10-K. The selected statement of
operations data for the years ended March 31, 1996 and 1997, and the selected
balance sheet data as of March 31, 1996, 1997 and 1998, are derived from
audited financial statements of the Company not included herein. The
historical results are not necessarily indicative of future results.
<TABLE>
<CAPTION>
Year Ended March 31,
---------------------------------------------
1996 1997 1998 1999 2000
------- ------- ------- -------- --------
(In thousands, except per share data)
<S> <C> <C> <C> <C> <C>
Statement of Operations Data:
Service revenues............... $ 2,525 $ 6,300 $11,317 $ 17,522 $ 29,647
Technology access revenues..... -- -- -- -- 2,250
------- ------- ------- -------- --------
Total revenues................. 2,525 6,300 11,317 17,522 31,897
Cost of revenues............... 1,424 4,181 9,825 20,072 31,183
------- ------- ------- -------- --------
Gross margin................... 1,101 2,119 1,492 (2,550) 714
Operating expenses:
Sales and marketing.......... 1,792 3,109 4,306 9,627 13,492
Engineering and development.. 162 275 799 1,642 3,972
General and administrative... 766 1,064 1,551 2,903 3,792
------- ------- ------- -------- --------
Total operating expenses... 2,720 4,448 6,656 14,172 21,256
------- ------- ------- -------- --------
Operating loss................. (1,619) (2,329) (5,164) (16,722) (20,542)
Interest expense, net.......... (131) (323) (471) (1,373) (1,199)
------- ------- ------- -------- --------
Net loss....................... (1,750) (2,652) (5,635) (18,095) (21,741)
Accretion on redeemable
convertible preferred stock... (263) (478) (1,069) (488) --
------- ------- ------- -------- --------
Net loss attributable to common
stockholders.................. $(2,013) $(3,130) $(6,704) $(18,583) $(21,741)
======= ======= ======= ======== ========
Basic and diluted net loss per
share......................... $ (1.07) $ (1.58) $ (3.31) $ (1.94) $ (1.55)
======= ======= ======= ======== ========
Shares used in computing basic
and diluted net loss per
share......................... 1,889 1,982 2,025 9,568 14,009
======= ======= ======= ======== ========
<CAPTION>
March 31,
---------------------------------------------
1996 1997 1998 1999 2000
------- ------- ------- -------- --------
(In thousands)
<S> <C> <C> <C> <C> <C>
Balance Sheet Data:
Cash, cash equivalents and
short-term investments........ $ 420 $ 3,081 $ 1,447 $ 23,012 $ 8,818
Total current assets........... 1,056 3,927 2,786 27,233 16,894
Total current liabilities...... 1,695 3,291 5,749 12,650 18,546
Capital lease obligations, net
of current portion............ 908 1,946 3,444 4,830 3,561
Total stockholders' equity
(deficit)..................... (2,762) (5,882) (12,414) 24,635 21,050
</TABLE>
12
<PAGE>
Item 7. Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion and analysis should be read in conjunction with the
"Selected Financial Data" and the Company's Consolidated Financial Statements
and Notes thereto included elsewhere in this Form 10-K. In addition to
historical information, this Annual Report contains forward-looking
statements. These forward-looking statements are subject to certain risks and
uncertainties that could cause actual results to differ materially from those
reflected in these forward-looking statements. Factors that might cause such a
difference include, but are not limited to, those discussed in the section
entitled "Management's Discussion and Analysis of Financial Condition and
Results of Operations--Factors That May Affect Future Results and Market Price
of Stock." Readers are cautioned not to place undue reliance on these forward-
looking statements, which reflect management's opinions only as of the date
hereof. The Company undertakes no obligation to revise or publicly release the
results of any revision to these forward-looking statements. Readers should
carefully review the risk factors described in other documents the Company
files from time to time with the Securities and Exchange Commission, including
the Quarterly Reports on Form 10-Q to be filed by the Company in fiscal year
2001.
OVERVIEW
Pilot provides comprehensive security services that incorporate high
bandwidth connectivity and enable secure electronic commerce over the
Internet. Pilot's services include secure access and gateway services, secure
hosting and electronic commerce services, and secure extranet and virtual
private networking services. The Company delivers its services from
geographically dispersed Network Security Centers that are connected through
its secure high performance Internet backbone.
The Company was incorporated in August 1992 and commenced operations in
1993. The Company opened its first Network Security Center in the San
Francisco metropolitan area in 1994, followed by three additional centers in
the Los Angeles, New York and Chicago metropolitan areas in 1995. The Company
has since commenced operations at Network Security Centers in the Boston,
Washington, D.C. and London metropolitan areas.
Customers subscribe to the Company's services for an initial setup fee plus
a fixed monthly fee. The Company's contracts with its customers are generally
based on a one-year term with renewal periods. The minimum first-year
commitment consists of an installation fee of $13,500 followed by a recurring
fee of $6,500 per month upon the completed installation of the services.
Service fees vary according to the services selected by the customer.
Installation fees are typically recognized as revenue over the installation
period, which is generally less than 60 days. The ongoing monthly fees are
billed one month in advance for the following month and recognized as revenue
when earned in the following month.
The Company has recently expanded and expects to continue to expand its
operating capacity, sales and marketing activities and the development of new
services by making significant investments in new and existing Network
Security Centers. This subjects the Company to relatively large increments of
fixed expenses in advance of potential future revenues. As a result, the
Company has incurred and expects to incur substantially higher costs of
revenues during these periods. The Company has and anticipates that it will
continue to add customers over time to utilize this planned capacity
expansion. However, because its services are offered on a subscription basis
rather than for an up front fee, revenues from any additional customers
increase gradually. As a result, although the planned capacity expansion may
potentially increase the Company's revenue and profitability over the long
term, the Company experienced an increase in net loss in fiscal 2000 and
expects to continue to experience significant net losses on a quarterly and
annual basis for the foreseeable future.
Since the Company's inception, it has experienced operating losses and
negative cash flows from operations in each quarterly and annual period. As of
March 31, 2000, the Company had an accumulated deficit of approximately $53.0
million. The revenue and income potential of the Company's business and market
is unproven, and the Company's limited operating history makes an evaluation
of the Company and its prospects difficult. The Company and its prospects must
be considered in light of the risks, expenses and difficulties
13
<PAGE>
encountered by companies in the new and rapidly evolving market for Internet
system and network management solutions. To address these risks, among other
things, the Company must market its brand name effectively, continue to
advance its security leadership in the marketplace, provide scalable, reliable
and cost-effective services, continue to grow its infrastructure to
accommodate new Network Security Centers and increased bandwidth utilization
of its network, expand its channels of distribution, retain and motivate
qualified personnel and continue to respond to competitive developments.
Failure of the Company to achieve market acceptance of its services would have
a material adverse effect on the Company's business, results of operations and
financial condition. There can be no assurance that the Company will ever
achieve profitability on a quarterly or an annual basis or will sustain
profitability if achieved. See "Item 7--Limited Operating History; History of
Losses."
RESULTS OF OPERATIONS
The following table sets forth, for the periods indicated, the percentage
relationship of certain items from the Company's statement of operations to
service revenues. This information has been derived from our consolidated
audited financials statements included in this Form 10-K. This information
should be read in conjunction with the Consolidated Financial Statements and
the Notes thereto.
<TABLE>
<CAPTION>
Year Ended March
31,
----------------------
1998 1999 2000
----- ------ -----
<S> <C> <C> <C>
Service revenues...................................... 100.0% 100.0% 92.9%
Technology access revenues............................ -- -- 7.1
----- ------ -----
Total revenues........................................ 100.0 100.0 100.0
Cost of revenues...................................... 86.8 114.5 97.8
----- ------ -----
Gross margin.......................................... 13.2 (14.5) 2.2
Operating expenses:
Sales and marketing................................. 38.1 54.9 42.3
Engineering and development......................... 7.1 9.4 12.5
General and administrative.......................... 13.6 16.6 11.8
----- ------ -----
Total operating expenses........................... 58.8 80.9 66.6
----- ------ -----
Operating loss........................................ (45.6) (95.4) (64.4)
Interest expense, net................................. (4.2) (7.9) (3.8)
----- ------ -----
Net loss.............................................. (49.8)% (103.3)% (68.2)%
===== ====== =====
</TABLE>
FISCAL YEARS ENDED MARCH 31, 1998, 1999 AND 2000
Service revenues. Service revenues consist of monthly fees for installation,
recurring services and, to a lesser extent, one-time fees for management and
consulting services such as security audits. The Company's service revenues
increased 55% from $11.3 million in fiscal 1998 to $17.5 million in fiscal
1999 and increased an additional 69% to $29.6 million in fiscal 2000. The
growth in the Company's service revenues over this period resulted primarily
from an increase in the number of customers and to a lesser extent from
increases in the number of service offerings and in service revenues per
customer.
Technology access revenues. The Company generates technology access revenues
when it sells access to its technologies and methodologies to enable other
companies to deliver the Company's Heuristic Defense Infrastructure services.
Technology access revenue is recognized upon a signed agreement and delivery
of the technology unless there are related services that are considered to be
essential to the utility of the technology. In fiscal 2000, Pilot sold
technology and methodologies to two companies for a total of $2.25 million.
Cost of revenues. The Company's cost of revenues is comprised primarily of
the Company's costs for network bandwidth, equipment costs and salaries and
benefits for the Company's customer service and operations personnel,
including its network engineers, backbone engineers, network management and
systems and installation personnel. Network bandwidth consists of costs for
access to and use of third-party communications networks.
14
<PAGE>
Cost of revenues increased from $9.8 million in fiscal 1998 to $20.1 million
in fiscal 1999 and to $31.2 million in fiscal 2000. The Company's cost of
service revenues as a percentage of service revenues increased from 86.8% in
fiscal 1998 to 114.5% in fiscal 1999 but dropped to 97.8% in fiscal 2000. The
increase in cost of revenues in absolute dollars was due to increased costs
associated with the build-out and operation of the Company's Network Security
Centers, including increased costs for its network bandwidth, equipment costs
and salaries and benefits for its customer service, engineering and operations
personnel. The reduction in cost of revenues as a percentage of revenues came
from better capacity utilization and, to a lesser extent, higher margins on
certain services. The Company expects the cost of revenues to increase on an
absolute basis at least through fiscal 2001 as a result of expected customer
expansion in the Company's Network Security Centers.
Sales and marketing. The Company's marketing and sales expenses are
comprised primarily of salaries, commissions and benefits for the Company's
marketing and sales personnel and marketing expenses for items such as
tradeshows and product literature. The Company's sales and marketing expenses
increased from $4.3 million in fiscal 1998 to $9.6 million in fiscal 1999 and
to $13.5 million in fiscal 2000. These increases were primarily the result of
hiring additional sales and marketing personnel in connection with the
Company's expansion of its operations. The cost of marketing programs was
approximately unchanged from fiscal 1999 to fiscal 2000. The Company expects
that sales and expenses will continue to increase in absolute dollars.
Engineering and development. The Company's engineering and development
expenses are comprised primarily of salaries and benefits for its engineering
and development personnel and fees paid to consultants. These individuals work
on researching changes in security threats and technology, development of new
processes and methodologies, and integration of best-of-breed components into
the Company's secure operating environment. The Company's engineering and
development expenses increased from $799,000 in fiscal 1998 to $1.6 million in
fiscal 1999 and to $4.0 million in fiscal 2000. The Company's security and
services development expenses grew between the comparison periods primarily
due to the addition of engineering personnel required to create and enhance
the Company's expanded service offerings. The Company expects that engineering
and development expenses will continue to increase in absolute dollars as the
Company makes additional investments in developing its secure electronic
commerce services.
General and administrative. The Company's general and administrative
expenses are comprised primarily of salaries and benefits for the Company's
general management and administrative personnel as well as fees paid for
professional services. The Company's general and administrative expenses
increased from $1.6 million in fiscal 1998 to $2.9 million in fiscal 1999 and
to $3.8 million in fiscal 2000. These increases were primarily the result of
increased hiring of general and administrative personnel, and costs for
consultants and professional services providers. These increased expenses
reflected the Company's need for additional general and administrative
personnel to handle the expansion of the Company's operations. General and
administrative costs are expected to increase in absolute dollars to the
extent the Company expands its operations.
Interest expense, net. The Company's net interest expense increased from
$471,000 in fiscal 1998 to $1.4 million in fiscal 1999 while falling to $1.2
million in fiscal 2000. The decrease in net interest expense between the most
recent fiscal periods was primarily due to a reduction in the amortization of
loan fees associated with warrants issued in connection with debt financing.
The amortization of these fees provided an additional $1.1 million in expense
in fiscal 1999 and $525,000 in fiscal 2000. To a lesser extent, there were
increases in interest expense between the comparison periods due to increased
borrowings as the Company entered into equipment loans and lease agreements to
finance the construction of its Network Security Centers. In fiscal 2000,
interest income fell by approximately $275,000 due primarily to lower average
cash balances.
Income tax benefit. There has been no provision for income taxes in fiscal
1998, 1999 and 2000 due to the Company's net losses. As of March 31, 2000, the
Company has approximately $51.7 million of operating loss carryforwards for
federal tax purposes. These expire at various periods through the year 2020.
Because of the uncertainties surrounding the Company's ability to utilize
those tax losses in future periods, the Company does not carry a corresponding
net tax asset in its financial statements.
15
<PAGE>
Net loss attributable to common stockholders. Net loss per share reflects a
charge for accretion on redeemable convertible preferred stock of $1.1 million
in fiscal 1998 and $488,000 in fiscal 1999. The Company no longer records a
charge for accretion on redeemable convertible preferred stock due to the
conversion of all outstanding preferred stock of the Company at the closing of
the public offering in fiscal 1999.
QUARTERLY RESULTS OF OPERATIONS
The following table sets forth certain unaudited statements of operations
data of the Company for each of the eight quarters in the period ended March
31, 2000 expressed as a percentage of the Company's net revenues. This
information has been derived from the Company's unaudited financial
statements, which, in management's opinion, have been prepared on
substantially the same basis as the audited financial statements and include
all adjustments, consisting only of normal recurring adjustments, necessary
for a fair presentation of the financial information for the quarters
presented. This information should be read in conjunction with the Financial
Statements and Notes thereto included elsewhere in this Form 10-K. The
operating results in any quarter are not necessarily indicative of the results
for any future period.
<TABLE>
<CAPTION>
Quarter Ended
-----------------------------------------------------------------------------------
June 30, Sept. 30, Dec. 31, Mar. 31, June 30, Sept. 30, Dec. 31, Mar. 31,
1998 1998 1998 1999 1999 1999 1999 2000
-------- --------- -------- -------- -------- --------- -------- --------
(In thousands)
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Statement of Operations
Data:
Service revenues........ $ 3,720 $ 3,770 $ 4,480 $ 5,552 $ 5,816 $ 7,130 $ 7,465 $ 9,236
Technology access
revenues............... -- -- -- -- -- -- 1,000 1,250
------- ------- ------- ------- ------- ------- ------- -------
Total revenues.......... 3,720 3,770 4,480 5,552 5,816 7,130 8,465 10,486
Cost of revenues........ 4,023 4,581 5,263 6,205 6,430 7,379 8,188 9,186
------- ------- ------- ------- ------- ------- ------- -------
Gross margin............ (303) (811) (783) (653) (614) (249) 277 1,300
Operating expenses:
Sales and marketing.... 2,134 2,134 2,724 2,635 2,938 3,218 3,342 3,994
Engineering and
development........... 299 386 386 571 635 767 1,134 1,436
General and
administrative........ 688 728 722 765 760 970 983 1,079
------- ------- ------- ------- ------- ------- ------- -------
Total operating
expenses.............. 3,121 3,248 3,832 3,971 4,333 4,955 5,459 6,509
------- ------- ------- ------- ------- ------- ------- -------
Operating loss.......... (3,424) (4,059) (4,615) (4,624) (4,947) (5,204) (5,182) (5,209)
Interest expense, net... (208) (1,031) (47) (87) (250) (37) (412) (500)
------- ------- ------- ------- ------- ------- ------- -------
Net loss................ $(3,632) $(5,090) $(4,662) $(4,711) $(5,197) $(5,241) $(5,594) $(5,709)
======= ======= ======= ======= ======= ======= ======= =======
As a Percentage of
Revenues:
Service revenues ....... 100% 100% 100% 100% 100% 100% 88.2% 88.1%
Technology access
revenues............... -- -- -- -- -- -- 11.8% 11.9%
------- ------- ------- ------- ------- ------- ------- -------
Total revenues.......... 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0
Cost of service
revenues............... 108.1 121.5 117.5 111.7 110.6 103.5 96.7 87.6
------- ------- ------- ------- ------- ------- ------- -------
Gross margin............ (8.1) (21.5) (17.5) (11.7) (10.6) (3.5) 3.3 12.4
Operating expenses:
Sales and marketing.... 57.4 56.6 60.8 47.5 50.5 45.1 39.5 38.1
Engineering and
development........... 8.0 10.2 8.6 10.3 10.9 10.8 13.4 13.7
General and
administrative........ 18.5 19.3 16.1 13.8 13.1 13.6 11.6 10.3
------- ------- ------- ------- ------- ------- ------- -------
Total operating
expenses.............. 83.9 86.1 85.5 71.6 74.5 69.5 64.5 62.1
------- ------- ------- ------- ------- ------- ------- -------
Operating loss.......... (92.0) (107.6) (103.0) (83.3) (85.1) (73.0) (61.2) (49.7)
Interest expense, net... (5.6) (27.4) (1.0) (1.6) (4.3) (0.5) (4.9) (4.7)
------- ------- ------- ------- ------- ------- ------- -------
Net loss................ (97.6)% (135.0)% (104.0)% (84.9)% (89.4)% (73.5) (66.1) (54.4)
======= ======= ======= ======= ======= ======= ======= =======
</TABLE>
Service design revenues. The Company's service revenues increased
sequentially each quarter. This growth in revenues resulted primarily from
increases in the number of customers as well as increases in the number of
service offerings and in revenues per customer.
Technology access revenues. The Company had technology access revenues of
$1.0 million and $1.25 million in the quarters ended December 31, 1999, and
March 31, 2000, respectively.
16
<PAGE>
Cost of revenues. The Company's cost of revenues increased in absolute
dollars sequentially each quarter. As a percentage of revenue, the Company's
cost of revenues as a percentage of revenues has fallen in each quarter of
fiscal 2000. The increases in cost of revenues in absolute dollars were
primarily the result of costs associated with expanding the Company's network
to provide both broader geographic coverage as well as increased types of
services. Additionally, the Company incurred higher than usual costs
throughout fiscal 1999 due to the conversion of its backbone network from a
"frame relay" network to an ATM network. This new protocol will allow the
Company to more efficiently and cost effectively expand its communications
bandwidth. The increases in costs also resulted from increased costs for
salaries, telecommunications, recruiting, temporary help and depreciation
associated with growth in customer services provided.
Sales and marketing. Sales and marketing expenses increased in absolute
dollars in each quarter of fiscal 2000 while falling as a percentage of
revenue. Increases in absolute dollars were primarily due to increases in
personnel, the timing of sales compensation and the timing of promotional
activities. The increase in sales and marketing expenses in the four quarters
ended March 31, 2000, is largely the result of an increase in sales and
marketing personnel from 42 to 64 people during that period.
Engineering and development. Engineering and development expenses have
increased in absolute dollars and as a percentage of revenue as a result of
continuing efforts to develop new security methodologies, integrate and
enhance best-of-breed third-party technologies to support the Company's
security and add new service offerings.
General and administrative. General and administrative expenses have
generally increased primarily as a result of additional personnel, recruiting
fees and consulting costs. The Company expects that general and administrative
expenses will continue to increase in absolute dollars.
LIQUIDITY AND CAPITAL RESOURCES
At March 31, 2000, the Company's cash, cash equivalents and short-term
investments totaled $8.8 million compared to cash, cash equivalents and short-
term investments of $23.0 million at March 31, 1999.
As of March 31, 2000, the Company had an $8.0 million equipment line of
credit and lease facility for financing of equipment purchases at interest
rates of approximately 15%. Borrowings under the facilities are repayable in
monthly installments of principal and interest over 48 months and are secured
by a lien on the financed equipment. As of March 31, 2000, the Company had
fully utilized these lines of credit and lease facilities. The Company intends
to secure additional equipment lease lines of credit to fund growth in capital
equipment purchases.
Cash used in operating activities was $1.9 million, $13.3 million and $14.9
million in fiscal 1998, 1999 and 2000, respectively. The primary use of cash
in operating activities was to fund on-going operations and support higher
levels of trade receivables as a result of year-over-year revenue growth. The
primary use of cash in investing was for capital equipment and leasehold
improvements to support increased capacity and services provided to customers.
Capital expenditures were $1.5 million, $8.2 million and $17.0 million in
fiscal 1998, 1999 and 2000, respectively. The major source of cash provided by
financing activities was from the issuance of common stock which provided
$43.3 million and $17.0 million in fiscal 1999 and 2000, respectively.
In June 2000, the Company sold 15,000 shares of convertible preferred stock
directly to an investor at a price of $1,000 per share. The gross proceeds
were $15.0 million. After transaction fees and costs estimated at $1.0
million, the net proceeds to the Company were approximately $14.0 million. At
the investor's option, the convertible preferred stock may be converted into
shares of common stock at the lower of 125% of the average market price
immediately prior to the transaction, specifically $18.266 per share, or 101%
of the average market price immediately prior to conversion. The convertible
preferred stock pays a dividend of 3% per annum which can be paid in cash or
common stock of the Company, at the Company's option. The convertible
preferred stock matures in two years and may be redeemed in either cash or
common stock at the option of the Company. Prior
17
<PAGE>
to maturity, the preferred stock cannot be converted into more than 19.99% of
Pilot's outstanding shares of common stock. This maximum number of shares of
common stock upon conversion includes shares of common stock that may be
issued as dividends. At maturity, the convertible preferred stock may be
converted into more than 19.99% of the Company's outstanding shares of common
stock only upon prior approval of the Company's shareholders. As additional
consideration, the Company issued a warrant to purchase 256,620 shares of
common stock at 120% of the average market price immediately prior to the
transaction, specifically $17.536 per share.
In April 2000, the Company received commitments for an additional $4 million
in capital equipment lease lines of credit from two lessors on terms
substantially similar to existing equipment leases.
On December 28, 1999, the Company entered into an agreement with Primus
Telecommunications Group, Inc. ("Primus") that included the purchase by Primus
of 919,540 shares of the Company's common stock for $16.3125 per share for a
total purchase price of $15.0 million. The $16.3125 per share price was the
closing price of the Company's common stock on December 27, 1999.
Additionally, the Company issued to Primus a warrant to purchase 200,000
shares of common stock at $25 per share. The warrant is exercisable for three
years following its issuance. On January 5, 2000, the Company received the
full amount of the purchase price in cash and the shares and warrant were
released to Primus.
On November 10, 1999, the Company completed an $8.0 million credit facility
with a financial institution consisting of a $5.0 million revolving line of
credit and a $3.0 million term loan. The line of credit is renewable in
successive one-year terms and the term loan matures in one year. Both loans
currently bear interest of 11% per annum. Additionally, the term loan must be
pre-paid, without penalty, if the Company raises more than $15 million in
equity. The credit facility is secured by the general assets of the Company.
As additional consideration, the Company issued a warrant to purchase 121,212
shares of common stock at $8.25 per share. The Company calculated a fair value
of the warrants of $1.0 million which amount will be capitalized and amortized
over the expected terms of the loans. At March 31, 2000, $348,000 of the
revolving line of credit remained available.
On October 19, 1998, the Company announced an open-market common stock
repurchase program under which the Company would repurchase up to 1.5 million
shares of its Common Stock. As of June 30, 1999, 450,936 shares had been
repurchased, at an aggregate cost to the Company of approximately $2.7
million. The Company does not anticipate making any additional repurchases
under this program.
On June 30, 1998, the Company completed a borrowing arrangement with two
lenders providing $6.0 million of short term financing bearing interest at
13.5% per annum. The loans expired in June 1999. The loans contained various
pre-payment options available after the Company's initial public offering date
of August 10, 1998. As additional consideration, the Company issued 150,000
warrants to purchase common stock at $11.20 per share. The Company calculated
a fair value of the warrants of $1.2 million which amount was capitalized and
amortized over the expected terms of the loans. One of the lenders exercised
its option for repayment of $3.0 million which was repaid in October 1998. On
July 1, 1999, the Company repaid the remaining $3.0 million liability to the
other lender.
On May 11, 1998, the Company negotiated a line of credit with a financial
institution for an aggregate amount of $1.5 million and was secured by assets
of the Company. This line of credit has since been repaid from proceeds of the
$3.0 million term loan and terminated.
The Company's working capital and capital requirements will depend upon
numerous factors including plans to incur substantial additional capital
expenditures primarily for additions to and expansions of its Network Security
Centers, developing, acquiring or licensing new applications and technologies,
and the level of resources that the Company devotes to its sales and marketing
activities. In addition to the $30.0 million in aggregate equity investment in
June 2000 and December 1999 and $8.0 million credit facility completed in
November 1999, the Company believes that it will require additional equity
financing, which it is actively pursuing. In addition, the Company will pursue
additional equipment lease financing. However, there can be no assurance that
the Company will be successful in generating anticipated levels of cash from
operations or in obtaining
18
<PAGE>
equity or equipment lease financing. If the Company is unable to generate
sufficient cash flow from operations, or is unable to obtain additional equity
or equipment lease financing, it may be required to sell assets, scale down
its operations and expansion plans, refinance all or a portion of its existing
indebtedness or obtain other sources of financing earlier than planned, any of
which could have a material adverse impact on the Company's business, results
of operations and financial condition. There can be no assurance that any such
refinancing would be available on commercially reasonable terms, or at all, or
that any other financing could be obtained.
YEAR 2000 RISKS
The Company experienced no material adverse effects from the Year 2000
problem and does not believe it will incur significant incremental costs in
order to comply with Year 2000 requirements in the foreseeable future.
FACTORS THAT MAY AFFECT FUTURE RESULTS AND MARKET PRICE OF STOCK
The Company operates in a rapidly changing environment that involves
numerous risks, some of which are beyond the Company's control. The following
discussion highlights some of these risks.
Future Capital Needs. The Company's working capital and capital requirements
will depend upon numerous factors including plans to incur substantial
additional capital expenditures primarily for additions to and expansions of
its Network Security Centers, developing, acquiring or licensing new
applications and technologies, and the level of resources that the Company
devotes to its sales and marketing activities. In addition to the $30.0
million in aggregate equity investment in June 2000 and December 1999 and $8.0
million credit facility completed in November 1999, the Company believes that
it will require additional equity financing, which it is actively pursuing. In
addition, the Company will pursue additional equipment lease financing.
However, there can be no assurance that the Company will be successful in
generating anticipated levels of cash from operations or in obtaining equity
or equipment lease financing. If the Company is unable to generate sufficient
cash flow from operations, or is unable to obtain additional equity or
equipment lease financing, it may be required to sell assets, scale down its
operations and expansion plans, refinance all or a portion of its existing
indebtedness or obtain other sources of financing earlier than planned, any of
which could have a material adverse impact on the Company's business, results
of operations and financial condition. There can be no assurance that any such
refinancing would be available on commercially reasonable terms, or at all, or
that any other financing could be obtained.
Limited Operating History; History Of Losses. The Company began operations
in 1993, and has experienced operating losses and negative cash flows from
operations in each quarterly and annual period. As of March 31, 2000, the
Company had an accumulated deficit of approximately $53.0 million. The revenue
and income potential of the Company's business and market is unproven, and the
Company's limited operating history makes an evaluation of the Company and its
prospects difficult. The Company has recently made and expects to continue
making significant investments in security technologies, new and existing
Network Security Centers, sales and marketing activities, and the development
of new services. As a result, the Company experienced a decline in gross
margin and an increase in net loss in fiscal 1998, 1999 and 2000 and expects
to continue experiencing significant net losses on a quarterly and annual
basis for the foreseeable future. Failure of the Company's services to achieve
market acceptance would have a material adverse effect on the Company's
business, results of operations and financial condition. There can be no
assurance that the Company will ever achieve profitability on a quarterly or
an annual basis or will sustain profitability if achieved.
Potential Fluctuations In Results Of Operations. The Company derives revenue
from its customers primarily through initial setup fees and ongoing monthly
service charges. For each new customer, the Company must incur costs in
anticipation of the customer's decision to use the Company's services and in
advance of the receipt of sufficient revenues to repay these costs and provide
a return on the Company's investment. As a result, a relatively large portion
of the Company's expenditures are fixed in the short-term, and the Company's
success is substantially dependent on the continued growth in its customer
base and the retention of its customers for sufficient periods to provide
returns on the Company's investment. There can be no assurance that the
19
<PAGE>
Company's customers will maintain or renew their commitments to use the
Company's services. The Company typically experiences a lengthy sales cycle
for its services, particularly given the importance to customers of adequately
securing Internet connectivity for electronic commerce and the need to educate
them regarding the requirements for effective network security. Changes in the
rate of growth in the Company's customer base, customer renewal rates and the
sales cycle for the Company's services, have caused, or are expected in the
future to cause, significant fluctuations in the Company's results of
operations on a quarterly and an annual basis.
For these and other reasons, in some future quarters, the Company's results
of operations may fall below the expectations of securities analysts or
investors, which could have a material adverse effect on the market price of
the Company's Common Stock.
Risks Associated with Third-Party Delivery of Heuristic Defense
Infrastructure. In fiscal 2000, Pilot sold technology and consulting services
to enable two telecommunications carriers to embed Pilot's Heuristic Defense
Infrastructure in several of their security centers. As part of the
relationship with these third parties, they will pay Pilot a recurring fee
based on the total revenue generated through the Heuristic Defense
Infrastructure. In exchange, Pilot will provide security monitoring for
network traffic using the Heuristic Defense Infrastructure. This will provide
Pilot with faster, less expensive access to established customer bases and
geographic reach. While the telecommunications carriers have committed
significant capital and operational resources to these projects, as of March
31, 2000, none of these third-party centers are operational. There are no
contractual guarantees that these centers will ever be operational or that
they will generate material revenues or earnings for Pilot. To the extent one
or both of the third-party carriers elects not to proceed with using the
Heuristic Defense Infrastructure or if the implementation is materially
delayed, there could be a material adverse effect on the Company's ability to
expand operations, operating results and financial condition.
Risks Associated With Security Breaches. The Company's success is
substantially dependent on the continued confidence of its current and future
customers that the Company provides superior network security protection.
Despite the Company's focus on Internet security, there can be no assurance
that the Company will be able to stop unauthorized attempts, whether made
unintentionally or by computer "attackers," to gain access to or disrupt the
network operations of the Company's customers. The Company's Heuristic Defense
Infrastructure delivered through its Network Security Centers is designed to
prevent unauthorized access to customers' networks from the Internet. Any
failure by the Company to stop unauthorized access from the Internet or
disruptions to related Internet operations of its customers could materially
adversely affect such customers and the Company. Although the Company
generally limits warranties and liabilities relating to security in its
customer contracts, the Company's customers may seek to hold the Company
responsible for any losses suffered by the customer as a result of
unauthorized access to customers' network systems from the Internet. This
could result in liability to the Company, which could have a material adverse
effect upon its business, operating results and financial condition. Moreover,
computer attackers from the Internet could infiltrate the Company's network
and seek to sabotage its network or services by creating bugs or viruses or
through other means. In addition, any adverse publicity resulting from any
such unauthorized access could deter future customers from using the Company's
services and could cause current customers to cease using the Company's
services, which could have a material adverse effect upon the Company's
business, operating results and financial condition.
Risks Associated With The Emerging Market For Outsourced Network Security
Services. The market for Internet security monitoring, detection and defense
services in general is new and rapidly evolving. If the market for such
services fails to grow or grows more slowly than the Company currently
anticipates, the Company's business, operating results and financial condition
would be materially and adversely affected.
Risks Of Business Expansion And Management Of Growth. The Company intends to
expand domestically and internationally by adding Network Security Centers in
new locations and expanding Network Security Centers in existing locations.
The Company's inability to manage effectively its expansion, including any
disruption of service to current customers, would have a material adverse
effect upon the Company's business, results of operations and financial
condition.
20
<PAGE>
In addition, the Company will be required to expend substantial resources
for leases and improvements of facilities, purchases of equipment,
implementation of multiple telecommunications connections and hiring of
network, administrative, customer support, and sales and marketing personnel.
Furthermore, any problems encountered in connection with the expansion of
existing Network Security Centers may cause the interruption of service to
current customers.
The Company has recently hired large numbers of new employees. This growth
has placed and may continue to place a significant strain on the Company's
financial, management, operational and other resources. If the Company's
executives were unable to manage growth effectively, the Company's business,
results of operations and financial condition would be materially adversely
affected.
Competition. The market served by the Company is new, rapidly evolving,
highly competitive and largely undefined. There are few general barriers to
entry, and the Company expects that it will face additional competition from
existing competitors and new market entrants in the future. There can be no
assurance that the Company will have the resources or expertise to compete
successfully in the future.
The Company competes with a broad range of products and services. Many of
the Company's competitors have substantially greater financial, technical and
marketing resources, larger customer bases, longer operating histories,
greater name recognition and more established relationships in the industry
than the Company. As a result, certain of these competitors may be able to
develop and expand their network infrastructures and service offerings more
quickly, adapt to new or emerging technologies and changes in customer
requirements more quickly, take advantage of acquisition and other
opportunities more readily, devote greater resources to the marketing and sale
of their products and adopt more aggressive pricing policies than the Company.
In addition, the Company believes that the businesses in which the Company
competes are likely to encounter consolidation in the near future, which could
result in increased price and other competition that could have a material
adverse effect on the Company's business, results of operations and financial
condition.
Risk Of System Failure. The Company's success depends on the excellence of
security protection and uninterrupted operation of its network infrastructure.
Despite existing and planned precautions by the Company, the occurrence of a
natural disaster or other unanticipated problems at one or more of the
Company's Network Security Centers could result in interruptions in the
services provided by the Company. Any damage to or failure of the Company's
systems or those of its service providers could result in reductions in, or
terminations of, services supplied to the Company's customers. Such reductions
or terminations in service could materially and adversely impact the Company's
customers, which could have a material adverse effect on the Company's
business, results of operations and financial condition.
Risks Associated With International Operations. A key component of the
Company's long-term strategy is to expand into international markets. If
revenue generated by any international Network Security Center is not adequate
to offset the expense of establishing and maintaining any such international
operation, the Company's business, results of operations and financial
condition could be materially adversely affected. In addition, the Company
faces certain risks inherent in conducting business internationally, any of
which could adversely affect the Company's international operations.
Dependence Upon Scalability Of The Company's Network. The Company must
continue to expand and adapt its network infrastructure as the number of
customers and the amount of information they wish to transmit increases, and
as customer requirements change. The expansion and adaptation of the Company's
telecommunications infrastructure will require substantial financial,
operational and management resources. Due to the limited deployment of the
Company's services to date, the ability of the Company's network to connect
and manage a substantially larger number of customers at high transmission
speeds is as yet unknown, and the Company faces risks related to the network's
ability to operate with higher customer levels while maintaining superior
performance. The Company's failure to achieve or maintain high capacity data
transmission could significantly reduce customer demand for its services and
have a material adverse effect on its business, results of operations and
financial condition. There can be no assurance that the Company will be able
to expand or adapt its telecommunications infrastructure to meet additional
demand or its customers' changing requirements.
21
<PAGE>
Dependence Upon Third Party Network Infrastructure Providers. The Company's
success will depend upon third party network infrastructure providers. In
addition, the Company relies on a number of public and private peering
interconnections (i.e., arrangements among access providers to carry traffic
of each other) to deliver its services. If the carriers that operate the
Internet exchange points ("IXPs") were to discontinue their support of the
peering points or to refuse to offer services to the Company and no
alternative providers were to emerge, or such alternative providers were to
increase the cost of utilizing the IXPs, the transmission of network traffic
by the Company would be significantly constrained. If the Company were unable
to access on a cost- effective basis alternative networks to distribute its
customers' content or pass through any additional costs of utilizing these
networks to its customers, the Company's business, results of operations and
financial condition could be materially adversely affected.
Dependence On Other Third-Party Relationships. The Company is dependent on
other companies to supply certain key components of its telecommunications
infrastructure and system and network management solutions that, in the
quantities and quality demanded by the Company, are available only from sole
or limited sources. Any failure to obtain required components or software on a
timely basis and at an acceptable cost would have a material adverse effect on
the Company's business, results of operations and financial condition. The
Company also intends to develop alternative distribution and lead generation
channel partners for the Company's services, such as systems integration firms
and bandwidth providers. Any failure by the Company to develop these channel
partners could materially and adversely impact the ability of the Company to
generate increased revenues, which could have a material adverse effect on the
Company's business, results of operations and financial condition.
Rapid Technological Change; Evolving Industry Standards. The Company's
future success will depend, in part, on its ability to offer services that
incorporate leading technology, address the increasingly sophisticated and
varied needs of its current and prospective customers and respond to
technological advances and emerging industry standards and practices on a
timely and cost-effective basis. The market for the Company's services is
characterized by rapidly changing and unproven technology, evolving industry
standards, changes in customer needs, emerging competition and frequent new
service introductions. There can be no assurance that future advances in
technology will be beneficial to, or compatible with, the Company's business
or that the Company will be able to incorporate such advances on a cost-
effective and timely basis into its business. The Company believes that its
ability to compete successfully is also dependent upon the continued
compatibility and interoperability of its services with products, services and
architectures offered by various vendors as part of the Company's services.
There can be no assurance that such products will be compatible with the
Company's infrastructure or that such products will adequately address
changing customer needs. In addition, there can be no assurance that products,
services or technologies developed by others will not render the Company's
services uncompetitive or obsolete.
Dependence On Key Personnel. The Company's success depends in significant
part upon the continued services of its key technical, sales and senior
management personnel, including the Company's President and Chief Executive
Officer, Marketta Silvera, and the Company's Chief Technology Officer, Thomas
Wadlow. Any officer or employee of the Company can terminate his or her
relationship with the Company at any time. The loss of the services of one or
more of the Company's key employees or the Company's failure to attract
additional qualified personnel could have a material adverse effect on the
Company's business, results of operations and financial condition.
Risks Associated With Information Disseminated Through The Company's
Network. The law relating to the liability of on-line services companies and
Internet access providers for information carried on or disseminated through
their networks is currently unsettled. It is possible that claims could be
made against on-line services companies and Internet access providers under
both United States and foreign law for defamation, negligence, copyright or
trademark infringement, or other theories based on the nature and content of
the materials disseminated through their networks. The imposition upon the
Company and other Internet network providers of potential liability for
information carried on or disseminated through their systems could require the
22
<PAGE>
Company to implement measures to reduce its exposure to such liability, which
may require the expenditure of substantial resources, or to discontinue
certain service or product offerings.
Protection And Enforcement Of Intellectual Property Rights. The Company
relies on a combination of copyright, trademark, patent, service mark and
trade secret laws and contractual restrictions to establish and protect
certain proprietary rights in technology underlying its services. There can be
no assurance that patents or trademarks will be issued or granted from
currently pending or any future applications, or that any patents or
trademarks that may be issued or granted will be sufficient in scope or
strength to provide meaningful protection or any commercial advantage to the
Company. The laws of certain foreign countries may not protect the Company's
products, services or intellectual property rights to the same extent as do
the laws of the United States.
There can be no assurance that contractual arrangements or other steps taken
by the Company to protect its intellectual property will prove sufficient to
prevent infringement of or misappropriation of the Company's technology or to
deter independent third-party development of similar technologies. Any such
infringement or misappropriation, should it occur, could have a material
adverse effect on the Company's business, results of operation and financial
condition.
To date, the Company has not been notified that the Company's products
infringe the proprietary rights of third parties, but there can be no
assurance that third parties will not claim infringement or indemnification by
the Company with respect to current or future products. Any such claim,
whether meritorious or not, could be time-consuming, result in costly
litigation, cause product installation delays, prevent the Company from using
important technologies or methods, subject the Company to substantial damages,
or require the Company to enter into royalty or licensing agreements. As a
result, any such claim could have a material adverse effect upon the Company's
business, results of operations and financial condition.
Risk of Future Dilution. As described in "Item 6. Selected Financial Data--
Liquidity and Capital Resources." in June 2000, Pilot sold an investor 15,000
shares of convertible preferred stock for $1,000 per share. The convertible
preferred stock can be converted at the investor's option into shares of
common stock at the lower of $18.266 per share or 101% of the market price for
Pilot's common stock immediately preceding conversion. To the extent that the
market price for Pilot's common stock falls substantially, there is a risk of
material dilution to pre-conversion owners of common stock.
Item 7A. Quantitative and Qualitative Disclosures About Market Risk.
The Company has limited exposure to financial market risks, including
changes in interest rates. The fair value of Pilot's investment portfolio or
related income would not be significantly impacted by a 100 basis point
increase or decrease in interest rates due mainly to the short-term nature of
the major portion of our investment portfolio. An increase or decrease in
interest rates would not significantly increase or decrease interest expense
on debt obligations due to the fixed nature of the Company's debt obligations.
Pilot's foreign operations are limited in scope and thus the Company is not
materially exposed to foreign currency fluctuations.
Item 8. Financial Statements and Supplementary Data.
The index to the audited financial statements, financial schedules and the
report of the independent auditors appears in Part IV of this Form 10-K.
Item 9. Changes in and Disagreements with Accountants on Accounting and
Financial Disclosure.
Not applicable.
23
<PAGE>
PART III
Item 10. Directors and Executive Officers of the Company
The information regarding directors required by Item 10 is incorporated by
reference from the Company's definitive proxy statement for its annual
stockholders' meeting to be held on September 14, 2000.
Item 11. Executive Compensation
The information required by Item 11 is incorporated by reference from the
Company's definitive proxy statement for its annual stockholders' meeting to
be held on September 14, 2000. The information specified in Item 402 (k) and
(l) of Regulation S-K and set forth in the Company's definitive proxy
statement for its annual stockholders' meeting to be held on September 14,
2000 is not incorporated herein by reference.
Item 12. Security Ownership Of Certain Beneficial Owners And Management
The information required by Item 12 is incorporated by reference from the
Company's definitive proxy statement for its annual stockholders' meeting to
be held on September 14, 2000.
Item 13. Certain Relationships and Related Transactions
The information required by Item 13 is incorporated by reference from the
Company's definitive proxy statement for its annual stockholders' meeting to
be held on September 14, 2000.
PART IV
Item 14. Exhibits, Financial Statement Schedules and Reports on Form 8-K.
(a)The following documents are filed as part of this report:
(1)Financial Statements and Report of KPMG LLP.
(2)Financial Statement Schedules
(3)Exhibits (numbered in accordance with Item 601 of Regulation S-K)
<TABLE>
<CAPTION>
Exhibit
No. Description
------- -----------
<C> <S>
Independent Auditors' Report on Financial Statement Schedule and
23.1 Consent
27.1 Financial Data Schedule.
</TABLE>
(b)Reports on Form 8-K
January 5, 2000. On January 5, 2000, Pilot Network Services, Inc. (the
"Company") issued a press release announcing that on December 28, 1999 the
Company and PRIMUS Telecommunications Group, Incorporated ("Primus") had
entered into a strategic business relationship. As part of such relationship,
Primus purchased from the Company 919,540 newly-issued shares of the Company's
common stock for $16.3125 per share, which was the closing price of the
Company's common stock on NASDAQ on December 27, 1999. Primus also received
warrants to purchase 200,000 shares of the Company's common stock at an
exercise price of $25.00 per share. In addition, K. Paul Singh, Chairman and
Chief Executive Officer of Primus, was elected to the Board of Directors of
the Company.
24
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
PILOT NETWORK SERVICES, INC.
/s/ Marketta Silvera
By: _________________________________
M. Marketta Silvera
President and Chief Executive
Officer
Date: June 30, 2000
POWER OF ATTORNEY
KNOW ALL PERSONS BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints M. Marketta Silvera and William C. Leetham,
jointly and severally, his or her attorneys-in-fact, each with the power of
substitution, for her or him in any and all capacities, to sign any amendments
to this Report on Form 10-K, and to file the same, with exhibits thereto and
other documents in connection therewith with the Securities and Exchange
Commission, hereby ratifying and confirming all that each of said attorneys-
in-fact, or his or her substitute or substitutes may do or cause to be done by
virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
Signature Title Date
--------- ----- ----
<S> <C> <C>
/s/ M. Marketta Silvera President, Chief Executive June 30, 2000
______________________________________ Officer and Director
M. Marketta Silvera (Principal Executive
Officer)
/s/ William C. Leetham Senior Vice President, June 30, 2000
______________________________________ Finance and
William C. Leetham Administration, Chief
Financial Officer,
Treasurer and Secretary
(Principal Financial and
Accounting Officer)
/s/ Shanda Bahles Director June 30, 2000
______________________________________
Shanda Bahles
/s/ Thomas Kelly Director June 30, 2000
______________________________________
Thomas Kelly
/s/ Thomas O'Rourke Director June 30, 2000
______________________________________
Thomas O'Rourke
/s/ K. Paul Singh Director June 30, 2000
______________________________________
K. Paul Singh
</TABLE>
25
<PAGE>
PART IV
PILOT NETWORK SERVICES, INC.
INDEX TO FINANCIAL PAGES
<TABLE>
<S> <C>
Independent Auditors' Report................................................ F-2
Consolidated Balance Sheets................................................. F-3
Consolidated Statements of Operations....................................... F-4
Consolidated Statements of Comprehensive Loss............................... F-5
Consolidated Statements of Stockholders' Equity (Deficit)................... F-6
Consolidated Statements of Cash Flows....................................... F-7
Notes to Consolidated Financial Statements.................................. F-8
</TABLE>
F-1
<PAGE>
INDEPENDENT AUDITORS' REPORT
The Boards of Directors
Pilot Network Services, Inc.:
We have audited the accompanying consolidated balance sheets of Pilot
Network Services, Inc. and subsidiary (the "Company") as of March 31, 1999 and
2000, and the related consolidated statements of operations, comprehensive
loss, stockholders' equity (deficit) and cash flows for each of the years in
the three-year period ended March 31, 2000. These consolidated financial
statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these consolidated financial
statements based on our audits.
We conducted our audits in accordance with generally accepted auditing
standards in the United States. Those standards require that we plan and
perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on
a test basis, evidence supporting the amounts and disclosures in the financial
statements. An audit also includes assessing the accounting principles used
and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a
reasonable basis for our opinion.
In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Pilot
Network Services, Inc. and subsidiary as of March 31, 1999 and 2000, and the
results of their operations and their cash flows for each of the years in the
three-year period ended March 31, 2000, in conformity with generally accepted
accounting principles.
/s/ KPMG LLP
June 30, 2000
F-2
<PAGE>
PILOT NETWORK SERVICES, INC.
CONSOLIDATED BALANCE SHEETS
(in thousands, except share and per share data)
<TABLE>
<CAPTION>
March 31,
------------------
1999 2000
-------- --------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents................................ $ 10,660 $ 7,920
Short-term investments................................... 12,352 898
Trade receivables, less allowance for doubtful accounts
of $157 and $389 as of March 31, 1999 and 2000,
respectively............................................ 3,438 7,233
Prepaid and other current assets......................... 783 843
-------- --------
Total current assets................................... 27,233 16,894
Property and equipment, net................................ 14,184 24,624
Other assets............................................... 698 1,639
-------- --------
$ 42,115 $ 43,157
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Accounts payable......................................... $ 2,334 $ 5,352
Accrued expenses......................................... 1,675 2,067
Line of credit........................................... 1,439 4,652
Term loan................................................ 3,000 3,000
Current portion of capital lease obligation.............. 2,175 2,275
Deferred revenue......................................... 2,027 1,200
-------- --------
Total current liabilities.............................. 12,650 18,546
Capital lease obligations, net of current portion.......... 4,830 3,561
-------- --------
Total liabilities...................................... 17,480 22,107
Stockholders' equity:
Common stock, $0.001 par value; 40,000,000 shares
authorized; 13,913,024 and 15,487,063 shares issued and
outstanding as of March 31, 1999 and March 31, 2000,
respectively............................................ 14 15
Additional paid-in capital............................... 59,563 77,035
Accumulated other comprehensive income................... 127 39
Deferred stock compensation.............................. (1,097) (326)
Accumulated deficit...................................... (31,278) (53,019)
Treasury stock, 450,936 shares of common stock at cost as
of March 31, 1999 and 2000.............................. (2,694) (2,694)
-------- --------
Total stockholders' equity............................. 24,635 21,050
-------- --------
$ 42,115 $ 43,157
======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-3
<PAGE>
PILOT NETWORK SERVICES, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(in thousands, except per share data)
<TABLE>
<CAPTION>
Year Ended March 31,
-----------------------------
1998 1999 2000
------- -------- --------
<S> <C> <C> <C>
Service revenues............................... $11,317 $ 17,522 $ 29,647
Technology access revenues..................... -- -- 2,250
------- -------- --------
Total revenues............................. 11,317 17,522 31,897
Cost of revenues............................... 9,825 20,072 31,183
------- -------- --------
Gross margin................................... 1,492 (2,550) 714
Operating expenses:
Sales and marketing.......................... 4,306 9,627 13,492
Engineering and development.................. 799 1,642 3,972
General and administrative................... 1,551 2,903 3,792
------- -------- --------
Total operating expenses................... 6,656 14,172 21,256
------- -------- --------
Operating loss................................. (5,164) (16,722) (20,542)
Interest expense, net.......................... (471) (1,373) (1,199)
------- -------- --------
Net loss....................................... (5,635) (18,095) (21,741)
Accretion on redeemable convertible preferred
stock......................................... (1,069) (488) --
------- -------- --------
Net loss attributable to common stockholders... $(6,704) $(18,583) $(21,741)
======= ======== ========
Basic and diluted net loss per share........... $ (3.31) $ (1.94) $ (1.55)
======= ======== ========
Shares used in computing basic and diluted net
loss per share................................ 2,025 9,568 14,009
======= ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-4
<PAGE>
PILOT NETWORK SERVICES, INC.
CONSOLIDATED STATEMENTS OF COMPREHENSIVE LOSS
(in thousands)
<TABLE>
<CAPTION>
Year Ended March 31,
---------------------------
1998 1999 2000
------- -------- --------
<S> <C> <C> <C>
Net loss.......................................... $(5,635) $(18,095) $(21,741)
Other comprehensive income/(loss), net of income
tax:
Unrealized gain/(loss) from available-for-sale
securities..................................... -- 126 (87)
Foreign currency translation gain/(loss)........ -- 1 (1)
------- -------- --------
Comprehensive loss................................ $(5,635) $(17,968) $(21,829)
======= ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-5
<PAGE>
PILOT NETWORK SERVICES, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
Years Ended March 31, 1998, 1999 and 2000
(in thousands, except number of shares)
<TABLE>
<CAPTION>
Series A Convertible Accumulated
Preferred Stock Common Stock Additional Other Deferred Treasury Stock
------------------------------------------- Paid-in Comprehensive Stock -----------------
Shares Amount Shares Amount Capital Income Compensation Shares Amount
------------- -------------------- ------ ---------- ------------- ------------ -------- -------
<S> <C> <C> <C> <C> <C> <C> <C> <C> <C>
Balance March 31,
1997............. 1,400,000 $ 1 2,001,722 $ 2 $ 106 $-- $ -- -- $ --
Issuance of
common stock.... -- -- 72,706 -- 9 -- -- -- --
Repurchase of
common stock.... -- -- (23,892) -- (1) -- -- -- --
Accretion on
Series B, C, D,
E, and F
redeemable
convertible
preferred
stock........... -- -- -- -- -- -- -- -- --
Deferred
compensation
related to grant
of common stock
options......... -- -- -- -- 1,055 -- (1,055) -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- 164 -- --
Net loss........ -- -- -- -- -- -- -- -- --
------------- ------- ---------- ---- ------- ---- -------- -------- -------
Balance March 31,
1998............. 1,400,000 $ 1 2,050,536 $ 2 1,169 $-- $ (891) -- $ --
Issuance of
common stock,
net of issuance
costs........... 3,603,625 4 39,721 -- -- -- --
Repurchase of
common stock.... -- -- (104,167) -- (70) -- -- (450,936) (2,694)
Accretion on
Series B, C, D,
E, and F
redeemable
convertible
preferred
stock........... -- -- -- -- 2,390 -- -- -- --
Issuance of
common stock
warrants in
connection with
bridge
financing....... -- -- -- -- 1,200 -- -- -- --
Conversion of
Series A, B, C,
D, E, and F
convertible
preferred stock
to common
stock........... (1,400,000) (1) 8,363,030 8 13,834 -- -- -- --
Deferred
compensation
related to grant
of common stock
options......... -- -- -- -- 2,175 -- (2,175) -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- 1,113 -- --
Reversal of
deferred
compensation for
forfeited
options......... -- -- -- -- (856) -- 856 -- --
Other
comprehensive
gain............ -- -- -- -- -- 127 -- -- --
Net loss........ -- -- -- -- -- -- -- -- --
------------- ------- ---------- ---- ------- ---- -------- -------- -------
Balance March 31,
1999............. -- $ -- 13,913,024 $ 14 $59,563 $127 $ (1,097) (450,936) $(2,694)
Issuance of
common stock,
net of issuance
costs........... -- -- 1,604,248 1 16,969 -- -- -- --
Repurchase of
common stock.... -- -- (30,209) -- (23) -- -- -- --
Issuance of
common stock
warrants in
connection with
loan financing.. -- -- -- -- 1,000 -- -- -- --
Amortization of
deferred
compensation.... -- -- -- -- -- -- 297 -- --
Reversal of
deferred
compensation for
forfeited
options......... -- -- -- -- (474) -- 474 -- --
Other
comprehensive
loss............ -- -- -- -- -- (88) -- -- --
Net loss........ -- -- -- -- -- -- -- -- --
------------- ------- ---------- ---- ------- ---- -------- -------- -------
Balance March 31,
2000............. -- $ -- 15,487,063 $ 15 $77,035 $ 39 $ (326) (450,936) $(2,694)
============= ======= ========== ==== ======= ==== ======== ======== =======
<CAPTION>
Total
Accumulated Stockholders'
Deficit Equity
----------- -------------
<S> <C> <C>
Balance March 31,
1997............. $ (5,991) $ (5,882)
Issuance of
common stock.... -- 9
Repurchase of
common stock.... -- (1)
Accretion on
Series B, C, D,
E, and F
redeemable
convertible
preferred
stock........... (1,069) (1,069)
Deferred
compensation
related to grant
of common stock
options......... -- --
Amortization of
deferred
compensation.... -- 164
Net loss........ (5,635) (5,635)
----------- -------------
Balance March 31,
1998............. $(12,695) $(12,414)
Issuance of
common stock,
net of issuance
costs........... -- 39,725
Repurchase of
common stock.... -- (2,764)
Accretion on
Series B, C, D,
E, and F
redeemable
convertible
preferred
stock........... (488) 1,902
Issuance of
common stock
warrants in
connection with
bridge
financing....... -- 1,200
Conversion of
Series A, B, C,
D, E, and F
convertible
preferred stock
to common
stock........... -- 13,841
Deferred
compensation
related to grant
of common stock
options......... -- --
Amortization of
deferred
compensation.... -- 1,113
Reversal of
deferred
compensation for
forfeited
options......... -- --
Other
comprehensive
gain............ -- 127
Net loss........ (18,095) (18,095)
----------- -------------
Balance March 31,
1999............. $(31,278) $ 24,635
Issuance of
common stock,
net of issuance
costs........... -- 16,970
Repurchase of
common stock.... -- (23)
Issuance of
common stock
warrants in
connection with
loan financing.. -- 1,000
Amortization of
deferred
compensation.... -- 297
Reversal of
deferred
compensation for
forfeited
options......... -- --
Other
comprehensive
loss............ -- (88)
Net loss........ (21,741) (21,741)
----------- -------------
Balance March 31,
2000............. $(53,019) $ 21,050
=========== =============
</TABLE>
See accompanying notes to consolidated financial statements.
F-6
<PAGE>
PILOT NETWORK SERVICES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
<TABLE>
<CAPTION>
Year Ended March 31,
---------------------------
1998 1999 2000
------- -------- --------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss........................................ $(5,635) $(18,095) $(21,741)
Adjustments to reconcile net loss to net cash
used in operating activities:
Depreciation and amortization.................. 2,274 4,050 7,734
Amortization of deferred compensation.......... 164 1,113 297
Amortization of loan fee....................... -- 1,050 525
Provision for doubtful accounts................ 179 445 389
Changes in operating assets and liabilities:
Trade receivables............................. (520) (2,817) (4,184)
Prepaid and other assets...................... (261) (922) (526)
Accounts payable.............................. 1,475 277 3,018
Accrued expenses.............................. 122 1,074 392
Deferred revenue.............................. 284 485 (827)
------- -------- --------
Net cash used in operating activities....... (1,918) (13,340) (14,923)
------- -------- --------
Cash flows from investing activities:
Capital expenditures............................ (1,470) (8,225) (17,000)
Purchases of short-term investments............. -- (12,225) --
Proceeds from short-term investments............ -- -- 11,366
------- -------- --------
Net cash used in investing activities....... (1,470) (20,450) (5,634)
------- -------- --------
Cash flows from financing activities:
Net proceeds from issuance of redeemable
convertible preferred stock.................... 2,990 -- --
Net proceeds from issuance of common stock...... 9 43,325 16,970
Repurchase of common stock...................... (1) (70) (23)
Treasury stock purchases........................ -- (2,694) --
Proceeds from working capital line of credit.... -- 1,439 3,213
Proceeds from term loan......................... -- 6,000 3,000
Payments of term loan........................... -- (3,000) (3,000)
Principal payments of obligations under capital
leases......................................... (1,244) (1,997) (2,343)
------- -------- --------
Net cash provided by financing activities... 1,754 43,003 17,817
------- -------- --------
Net increase (decrease) in cash and cash
equivalents.................................... (1,634) 9,213 (2,740)
Cash and cash equivalents at beginning of
period......................................... 3,081 1,447 10,660
------- -------- --------
Cash and cash equivalents at end of period...... $ 1,447 $ 10,660 $ 7,920
======= ======== ========
Supplemental disclosure of cash flow information:
Cash paid for interest.......................... $ 568 $ 1,432 $ 1,424
======= ======== ========
Noncash financing activities:
Assets acquired under capital lease
obligations.................................... $ 3,319 $ 4,008 $ 1,174
======= ======== ========
Accretion of redeemable preferred stock......... $ 1,069 $ 488 $ --
======= ======== ========
Warrant issued in connection with debt
financing...................................... $ -- $ 1,200 $ 1,000
======= ======== ========
</TABLE>
See accompanying notes to consolidated financial statements.
F-7
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(1) DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Description of Business
Pilot Network Services, Inc. (the Company) was originally incorporated in
California on August 6, 1992, then reincorporated in Delaware on August 4,
1998. The Company provides comprehensive security services that incorporate
high-bandwidth connectivity and enable secure electronic commerce over the
Internet.
Basis of Presentation and Principles of Consolidation
Historically, the Company has incurred losses from operations. As of March
31, 2000, the Company had a deficit in working capital. To date, the Company
has funded its operations principally through the net proceeds of its initial
public offering in fiscal 1999 and various debt and long-term capital lease
transactions. Subsequent to March 31, 2000, the Company raised net proceeds of
approximately $14.0 million (see Note 9). In addition, in the future,
management expects to obtain additional funding through debt, long-term
capital lease, or equity transactions. Management believes that its current
cash balances, plus the proceeds from the transaction described in Note 9 and
funding that it expects to obtain in the future will be sufficient to enable
the Company to satisfy its obligations through fiscal 2001. However, there can
be no assurance that the Company can obtain additional funds on terms
agreeable to the Company. The accompanying consolidated financial statements
have been prepared assuming that the Company will continue as a going concern.
The accompanying consolidated financial statements include the accounts of
the Company and its wholly-owned subsidiary. All material intercompany
balances and transaction have been eliminated.
Revenue Recognition
Service revenues consist primarily of monthly fees for secure access and
hosting services, implementation and management services. Secure access and
hosting service fees are recognized ratably over the term of the contract,
generally one year. Installation fees and the related installation costs are
recognized ratably over the installation period, generally less than 60 days.
Management services, which include security audits and consulting
arrangements, are recognized as the service is performed.
The Company generates technology access revenues when it sells access to its
technologies and methodologies to enable other companies to deliver the
Company's Heuristic Defense Infrastructure services. Technology access revenue
is recognized upon a signed agreement and delivery of the technology unless
there are related services that are considered to be essential to the utility
of the technology.
Cash Equivalents and Short-term Investments
The Company considers all highly liquid instruments with a remaining
maturity of 90 days or less at the date of purchase to be cash equivalents.
The Company has classified all short-term investments as available-for-sale in
accordance with Statement of Financial Accounting Standards (SFAS) No. 115,
Accounting for Certain Investments in Debt and Equity Securities. Such short-
term investments consist primarily of U.S. corporate notes and are reported at
fair value with net unrealized gains or losses reported within shareholders'
equity. Realized gains and losses are reported based on the specific
identification method. For fiscal years 1998, 1999 and 2000, gross realized
gains and losses were not material.
Property and Equipment
Property and equipment are recorded at cost. Depreciation is computed using
the straight-line method based on estimated useful lives, generally over three
years. Depreciation expense includes amortization of assets recorded under
capital lease. Equipment held under capital leases is amortized over the
shorter of the lease term or the estimated useful life of the asset.
F-8
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Income Taxes
Deferred tax assets and liabilities are recognized for the future tax
consequences attributable to differences between financial statement carrying
amounts of existing assets and liabilities and their respective tax bases.
Deferred tax assets and liabilities are measured using enacted tax rates
expected to apply to taxable income in the years that those differences are
expected to be recovered or settled. The effect on deferred tax assets and
liabilities of a change in tax rates is recognized in income in the period
that includes the enactment date.
Accounting for Stock-Based Compensation
The Company uses the intrinsic value method to account for its stock-based
employee compensation plans. Compensation expense, if any, is amortized on an
accelerated basis over the vesting period of the individual options, generally
four years.
Impairment of Long-Lived Assets and Long-Lived Assets to be Disposed of
The Company evaluates the recoverability of its long-lived assets under SFAS
No. 121, Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of. This statement requires long-lived assets to be
evaluated for impairment whenever events or changes in circumstances indicate
that the carrying value of an asset may not be recoverable. If an asset to be
held and used is considered to be impaired, the carrying amount of that asset
is reduced to its fair value, resulting in a charge to income. Assets to be
disposed of are reported at the lower of the carrying amounts or fair value
less costs to sell.
Advertising
Advertising costs are expensed as incurred and are included in sales and
marketing expense. The Company had approximately $24,000, $71,000 and $20,000
in advertising costs for the years ended March 31, 1998, 1999 and 2000,
respectively.
Net Loss Per Share
Basic net loss per share is computed using the weighted average number of
common shares outstanding during the year. Diluted net loss per share is
computed using the weighted average number of common and dilutive common
equivalent shares outstanding during the year, using the as-if-converted
method for convertible preferred stock and the treasury stock method for
options and warrants. The effect of including convertible preferred stock,
options and warrants would have been anti-dilutive during all periods
presented and, as a result, such effect has been excluded from the computation
of diluted net loss per share.
Excluded from the computation of diluted earnings per share for the years
ended March 31, 1998, 1999 and 2000 are options to acquire 1,125,312,
1,870,350, and 2,276,082 shares, respectively, of common stock with a
weighted-average exercise prices of $0.68, $5.14 and $12.56, respectively,
because their effects would be anti-dilutive. Also excluded from the
computation of diluted earnings per share for the years ended March 31, 1998
and 1999 are 7,329,696 and 2,760,188 common share equivalents, respectively,
resulting from the conversion of the Series A, B, C, D, E and F preferred
stock upon completion of the Company's initial public offering because their
effects would be anti-dilutive.
Comprehensive Loss
The Company has adopted SFAS No. 130, Reporting Comprehensive Income, which
establishes standards for displaying comprehensive income and its components.
The tax effects on components of comprehensive loss are not significant.
F-9
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Concentration of Credit Risk
Financial instruments that may subject the Company to concentrations of
credit risk consist primarily of cash and cash equivalents, short term
investments and accounts receivable. Cash, cash equivalents and short term
investments are managed by a third-party firm under investment guidelines
established the Company. The Company's primary investment goal is preservation
of principal. By policy, corporate securities must be rated A1/P1 and no
single issuer, other than the U.S. Government, may represent more than 10% of
Pilot's investment portfolio.
The Company provides its services throughout the United States to a wide
user base. During the years presented, no single customer accounted for
greater than 10% of total revenues. The Company performs credit evaluations of
its customers' financial condition and, generally, does not require collateral
from its customers. Management makes estimates as to its credit losses and to
date its estimates have not differed materially from actual results. Overall,
credit risk is limited due to the large number of customers in differing
industries and geographic areas. At March 31, 2000, outstanding accounts
receivable from one customer amounted to $1.25 million or 17% of total
accounts receivable.
The Company purchases its network management hardware from a limited number
of suppliers.
Fair Value of Financial Instruments
The carrying value of cash, cash equivalents, accounts receivable, accounts
payable and accrued liabilities approximate fair value due to the short
maturity of those instruments. The carrying value of the line of credit, the
term loan and the capital lease obligations approximate fair value because
interest rates and yields for these instruments are consistent with yields
currently available to the Company for similar instruments.
Use of Estimates
The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosures of contingent assets and liabilities at the date of the
consolidated financial statements and the reported amounts of revenues and
expenses during the reporting period. Actual results could differ from those
estimates.
Reclassifications
Certain reclassifications have been made to the prior year financial
statements to conform such statements to the current year's presentation.
Recent Accounting Pronouncements
In June 1998, the Financial Accounting Standards Board issued SFAS No. 133,
Accounting for Derivative Instruments and Hedging Activities. This statement
establishes standards for derivative instruments and hedging activities. The
Company is required to adopt SFAS No. 133, as amended, in the first quarter of
fiscal year 2002. The Company does not anticipate that SFAS No. 133 will have
a material impact on its consolidated financial statements.
In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin No. 101 ("SAB 101"), Revenue Recognition in
Financial Statements. SAB 101 summarized certain of the SEC's view in applying
generally accepted accounting principles to revenue recognition. The Company
is required to
F-10
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
adopt SAB 101 in the fourth quarter of fiscal 2001. The SEC has recently
indicated it intends to issue further guidance with respect to adoption of
specific issues addressed by SAB 101. Until such time as this additional
guidance is issued, the Company is unable to assess the impact, if any, it may
have on its financial position or results of operations.
(2) PROPERTY AND EQUIPMENT
Property and equipment consisted of the following (in thousands):
<TABLE>
<CAPTION>
Year Ended
March 31,
---------------
1999 2000
------- -------
<S> <C> <C>
Network and computer equipment.............................. $14,232 $28,948
Furniture and fixtures...................................... 1,102 2,156
Purchased software.......................................... 1,225 2,020
Leasehold improvements...................................... 5,697 7,306
------- -------
22,256 40,430
Less: accumulated depreciation and amortization............. 8,072 15,806
------- -------
$14,184 $24,624
======= =======
</TABLE>
The gross amount of capitalized leased assets included in property and
equipment was approximately $11,881,000 and $13,055,000 and related
accumulated amortization was approximately $6,364,000 and $9,197,000 as of
March 31, 1999 and 2000, respectively.
(3) SHORT-TERM DEBT
On May 11, 1998, the Company negotiated a line of credit with a financial
institution for an aggregate amount of $1.5 million bearing 9.75% interest per
annum. In November 1999, this line of credit was fully repaid and the line of
credit was terminated.
On June 30, 1998, the Company completed a borrowing arrangement with two
lenders providing $6.0 million of short term financing bearing interest of
13.5% per annum. As additional consideration, the Company issued warrants to
purchase 150,000 share of common stock at $11.20 per share. The Company
calculated a fair value of the warrants of $1.2 million which amount was
capitalized and amortized over the terms of the loans. The fair value of the
warrants were calculated using the Black-Scholes option pricing using the
following assumptions: dividend yield--none; contractual life--3 years; risk
free interest rate--5%; volatility--85%. The loans contained various pre-
payment options available after the Company's initial public offering date of
August 10, 1998. One of the lenders exercised its option for repayment of $3.0
million which was repaid in October 1998. The other lender was repaid in July
1999. In fiscal 2000, warrants on 75,000 shares of common stock were converted
into 23,493 shares of common stock on a net-exercise basis. At March 31, 2000,
warrants to purchase 75,000 shares of common stock remain unexercised and
outstanding.
On November 10, 1999, the Company completed an $8.0 million credit facility
with a financial institution consisting of a $5.0 million revolving line of
credit and a $3.0 million term loan. The line of credit is renewable in
successive one-year terms and the term loan matures in November 2000. Both
loans currently bear interest of 11% per annum. Additionally, the term loan
must be pre-paid, without penalty, if the Company raises more than $15 million
in equity. The credit facility is secured by the general assets of the
Company. As additional consideration, the Company issued a warrant to purchase
121,212 shares of common stock at $8.25 per share. The Company calculated a
fair value of the warrant of $1.0 million which amount was capitalized and is
being
F-11
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
amortized over the one year term of the loans. The fair value of the warrant
was calculated using the Black-Scholes option pricing using the following
assumptions: dividend yield--none; contractual life--5 years; risk free
interest rate--5%; volatility--75%. At March 31, 2000, $348,000 of the
revolving line of credit remained available.
(4) COMMITMENTS
Leases
The Company has entered into equipment leases with various leasing
institutions providing for financing of equipment purchases of up to
$8,000,000 at varying interest rates. Borrowings under the leases are
generally repayable in monthly installments over periods ranging from 36 to 48
months with a mandatory buyout at the end of the lease term, and are secured
by a lien on the leased equipment.
The Company is obligated under certain non-cancelable operating leases for
office space and equipment expiring at various dates through 2009. Rent
expense for the years ended March 31, 1998, 1999 and 2000 was approximately
$636,000, $1,078,000 and $1,822,000, respectively.
The following is a schedule of future minimum payments required under
capital and operating leases that have initial or remaining non-cancelable
lease terms in excess of one year as of March 31, 2000 (in thousands):
<TABLE>
<CAPTION>
Capital Operating
leases leases
------- ---------
<S> <C> <C>
Year Ending March 31,
2001..................................................... $2,942 $ 2,595
2002..................................................... 2,426 1,808
2003..................................................... 1,397 1,223
2004..................................................... 237 1,149
2005..................................................... -- 849
Thereafter............................................... -- 2,216
------ -------
7,002 $ 9,840
Less: amount representing interest (at rates ranging from
14.5% to 14.7%)......................................... 1,166
------
5,836
Less current portion of capital lease obligations........ 2,275
------
Capital lease obligations, net of current portion........ $3,561
======
</TABLE>
401(k) Retirement Plan
Effective July 1, 1995, the Company established a 401(k) defined
contribution retirement plan (Retirement Plan) covering all full-time
employees with greater than one months' service. The Retirement Plan provides
for voluntary employee contributions from 1% to 15% of annual compensation,
subject to a maximum limit allowed by Internal Revenue Service guidelines. The
Company may contribute such amounts to the accounts of participants in the
Retirement Plan as determined by the Board of Directors. However, to date, the
Company has not made any contributions to the Retirement Plan.
F-12
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
(5) INCOME TAXES
The tax effects of temporary differences that give rise to significant
portions of the deferred tax assets and liabilities are presented below (in
thousands):
<TABLE>
<CAPTION>
March 31,
-----------------
1999 2000
-------- -------
<S> <C> <C>
Deferred tax assets (liabilities):
Net operating loss carryforwards........................ $ 10,348 21,057
Property and equipment--depreciation differences........ (42) 184
Research credit carryforwards........................... 211 404
Other reserves and accruals............................. 437 1,593
-------- -------
Total gross deferred tax assets....................... 10,954 23,238
Less valuation allowance................................ (10,954) (23,238)
-------- -------
Net deferred tax assets............................... $ -- --
======== =======
</TABLE>
The net increase in the valuation allowance was approximately and $7.1
million and $12.3 million for the years ended March 31, 1999 and 2000,
respectively. Due to recurring operating losses, the Company believes that
sufficient uncertainty exists with respect to future realization of these
deferred tax assets; therefore, it has established a valuation allowance
against all net deferred tax assets. The Company has net operating loss
carryforwards for federal income tax return purposes of approximately $51.7
million which can be used to reduce future taxable income. These carryforwards
expire beginning in 2008 through 2020. As of March 31, 2000, the Company had
state operating loss carryforwards of approximately $40.7 million. The state
net operating loss carryforwards expire in various amounts from 2000 through
2005. The Company also has federal and state research tax credit carryforwards
of approximately $223,000 and $181,000, respectively, as of March 31, 2000.
The federal research tax credits expire through 2020. The state research tax
credits carry forward indefinitely until utilized. Under the Tax Reform Act of
1986, the amounts of any benefit from net operating losses and credits that
can be carried forward may be limited in the event of an ownership change as
defined in the Internal Revenue Code, Section 382. The Company has incurred
ownership changes since inception. As a result, the Company's ability to
utilize net operating loss and credit carryforwards may be limited.
(6) STOCKHOLDERS' EQUITY
Convertible Preferred Stock and Redeemable Convertible Preferred Stock
As of March 31, 1998, the Company had 1,400,000 shares of Series A
convertible preferred stock issued and outstanding. Each share of preferred
stock was convertible, at the option of the holder, into fully paid shares of
common stock. The conversion rate was one-for-one, subject to adjustments for
stock dividends, stock splits and capital reorganizations and dilution.
In January 1994, the Company issued 1,661,644 shares of Series B redeemable
convertible preferred stock at $0.365 per share. In March 1995, the Company
issued 1,488,200 shares of Series D redeemable convertible preferred stock at
$0.875 per share. In December 1995 and January 1996, the Company issued
1,210,068 shares of Series C redeemable convertible preferred stock at $0.73
per share upon the exercise of warrants outstanding. In July 1996, the Company
issued 783,118 shares of Series E redeemable convertible preferred stock at
$2.00 per share. From March 1997 through February 1998, the Company issued
1,220,000 shares of Series F redeemable convertible preferred stock at $5.00
per share and warrants to purchase 600,000 shares of Series F preferred stock
at $6.00 per share, all of which were exercised on August 11, 1998.
F-13
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
On August 11, 1998, all shares of outstanding convertible preferred stock
and redeemable convertible preferred stock were automatically converted into
8,363,030 shares of common stock at a rate of one-for-one as a result of the
Company's initial public offering.
Common Stock and Warrants
On June 18, 1996, the Company entered into an agreement with AmeriData
Technologies Inc. (subsequently purchased by GE Capital Information
Technologies Solutions, Inc.) (AmeriData) whereby the Company granted
AmeriData options to purchase 200,000 shares of the Company's common stock at
$2.00 per share. In August 1998, AmeriData exercised options to purchase
100,000 shares of common stock. At March 31, 2000, options to purchase 100,000
shares of common stock remain unexercised and outstanding. The fair value of
the options granted to AmeriData was immaterial using the Black-Scholes option
pricing model and the following assumptions: no dividend yield; risk free
interest rate of 6.5%; volatility of 60%; contractual life--5 years; and a
fair value of common stock of $0.40.
In connection with lease financings, at March 31, 2000, the Company had
outstanding warrants for the purchase of 22,620 shares of common stock, at a
weighted average exercise price of $0.705. The fair value of the warrants was
calculated using the Black-Scholes option pricing model was not material,
using the following assumptions: dividend yield--none; expected life--
contractual term; risk free interest rate--6%; volatility--60%. In fiscal
2000, warrants on 112,754 shares of common stock were converted into 99,882
shares of common stock on a net-exercise basis.
On November 10, 1999, the Company completed an $8.0 million credit facility
with a financial institution consisting of a $5.0 million revolving line of
credit and a $3.0 million term loan. As additional consideration, the Company
issued a warrant to purchase 121,212 shares of common stock at $8.25 per
share. The Company calculated a fair value of the warrant of $1.0 million
which amount was capitalized and is being amortized over the one-year term of
the loans. The fair value of the warrant was calculated using the Black-
Scholes option pricing using the following assumptions: dividend yield--none;
contractual life--5 years; risk free interest rate--5%; volatility--75%.
On December 28, 1999, the Company entered into an agreement with Primus
Telecommunications Group, Inc. ("Primus") that included the purchase by Primus
of 919,540 shares of the Company's common stock for $16.3125 per share for a
total purchase price of $15.0 million. The $16.3125 per share price was the
closing price of the Company's common stock on December 27, 1999.
Additionally, the Company issued to Primus a warrant to purchase 200,000
shares of common stock at $25 per share. The warrant is exercisable for three
years following its issuance. The Company calculated a fair value of the
warrant of $1.3 million which was recorded as a component of equity. The fair
value of the warrant was calculated using the Black-Scholes option pricing
using the following assumptions: dividend yield--none; contractual life--3
years; risk free interest rate--5%; volatility--75%.
Stock Option Plans
During fiscal 1995, the Company adopted its 1994 Stock Option Plan and the
1994 Restricted Stock Purchase Plan. On April 17, 1997, the plans were merged
into a single plan (the "1994 Plan") and the authorized shares were increased
resulting in an aggregate 1,200,000 shares reserved for issuance. The plan, as
amended, allows the Board of Directors to issue nonqualified stock options,
incentive stock options or restricted stock to employees, officers, directors,
advisors or contractors of the Company.
The plan expires 10 years from the date of adoption. Options and restricted
stock are granted at fair market value at date of grant for incentive stock
options or no less than 85% of fair market value at the date of grant for
F-14
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
nonqualified options. Options and restricted stock generally vest over 4
years, with 25% vesting after one year and the remainder vesting ratably over
the remaining 36 months, and expire 10 years from grant date.
During fiscal 1999, the Company increased the shares reserved under the 1994
Plan by 1,000,000 shares and adopted its 1998 Stock Option Plan (the "1998
Plan"). The 1998 Plan reserved 1,000,000 shares plus annual increases limited
to the lesser of 500,000 shares, 3% of the Company's outstanding common stock,
or the number determined by the Board of Directors. During fiscal 2000, the
annual increase in the 1998 Plan was 404,082 authorized shares. Also during
fiscal 1999, the Company adopted the 1998 Directors Stock Option Plan which
reserves 200,000 shares of common stock and a 1998 Employee Stock Purchase
Plan which reserves 200,000 shares of common stock. The 1998 Employee Stock
Purchase Plan provides for automatic annual increases of the lesser of 100,000
shares, 1/2% or the Company's outstanding common stock or an amount determined
by the Board of Directors. During fiscal 2000, 81,972 shares were purchased
under the 1998 Employee Stock Purchase Plan.
During fiscal 2000, the 1994 Plan was terminated. Further, shareholders
voted to increase shares available under the 1998 Plan by 1,156,000 shares
plus up to an additional 400,000 shares from the 1994 Plan that subsequently
may be canceled and returned. As of March 31, 2000, options for 77,392 shares
from the 1994 Plan were cancelled and eligible for re-issue under the 1998
Plan.
The following table summarizes the combined stock option and restricted
stock activity for the 1994 Plan, the 1998 Plan and the 1998 Directors Stock
Plan for the three years ended March 31, 2000:
<TABLE>
<CAPTION>
Weighted
Available Average
for Grant Outstanding Exercise Price
---------- ----------- --------------
<S> <C> <C> <C>
Balances, March 31, 1997............ 206,180 461,958 $ 0.23
Authorized........................ 830,140 -- --
Granted........................... (1,020,000) 1,020,000 0.82
Exercised......................... -- (72,706) 0.12
Canceled.......................... 283,940 (283,940) 0.57
Repurchased....................... 23,892 -- 0.08
---------- --------- ------
Balances, March 31, 1998............ 324,152 1,125,312 0.68
Authorized........................ 2,200,000 -- --
Granted........................... (1,601,400) 1,601,400 6.98
Exercised......................... -- (393,625) 0.57
Canceled.......................... 462,737 (462,737) 4.59
Repurchased....................... 104,167 -- 0.67
---------- --------- ------
Balances, March 31, 1999............ 1,489,656 1,870,350 5.14
Authorized........................ 1,560,082 -- --
Granted........................... (1,685,000) 1,685,000 16.59
Exercised......................... -- (472,030) 3.82
Canceled.......................... 807,238 (807,238) 8.88
Repurchased....................... 30,209 -- 0.75
Terminated 1994 Plan.............. (1,327,356) -- --
Increase in 1998 Plan from returns
to 1994 Plan..................... 77,392 -- --
---------- --------- ------
Balances, March 31, 2000............ 952,221 2,276,082 $12.56
========== ========= ======
</TABLE>
F-15
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following table summarizes information about fixed stock options
outstanding at March 31, 2000:
<TABLE>
<CAPTION>
Options Outstanding Options Exercisable
---------------------------------------- ----------------------
Weighted
Average
Remaining Weighted Number Weighted
Number of Contractual Average of Average
Exercise Prices shares Life (in years) Exercise Price shares Exercise Price
--------------- --------- --------------- -------------- ------- --------------
<S> <C> <C> <C> <C> <C>
$ 0.09 -$ 6.00.......... 553,474 6.70 $ 3.01 227,616 $ 2.01
8.063- 13.00.......... 800,659 9.13 10.09 100,651 9.82
14.00 - 22.00.......... 698,949 9.19 16.57 16,692 14.42
27.127- 49.875......... 223,000 9.87 32.55 -- --
--------- -------
$ 0.09 -$49.875......... 2,276,082 $12.56 344,959 $ 4.89
========= ====== ======= ======
</TABLE>
The Company accounts for employee stock-based compensation using the
intrinsic value method. As such, compensation expense is recorded if on the
date of grant the current fair value per share of the underlying stock exceeds
the exercise price per share. With respect to certain options granted during
fiscal 1998 and the first quarter of fiscal 1999, the Company recorded
deferred compensation of $1,055,000 and $2,175,000, respectively, for the
difference at the grant date between the exercise price per share and the fair
value per share, based upon management's estimate of the fair value of the
Company's stock on the various grant dates of the common stock underlying the
options.
Had compensation cost for the Company's stock-based compensation plan been
determined consistent with SFAS No. 123, Accounting for Stock-Based
Compensation, the Company's net loss would have increased to the pro forma
amounts indicated below:
<TABLE>
<CAPTION>
Year ended March 31,
---------------------------
1998 1999 2000
------- -------- --------
<S> <C> <C> <C>
Net loss attributable to common stockholders
(in thousands):
As reported................................ $(6,704) $(18,583) $(21,741)
Pro forma.................................. (6,727) (19,596) (25,356)
Net loss per share:
As reported basic and diluted net loss per
share..................................... $ (3.31) $ (1.94) $ (1.55)
Pro forma basic and diluted net loss per
share..................................... $ (3.32) $ (2.05) $ (1.81)
</TABLE>
Under SFAS No. 123, the fair value of each option grant is estimated on the
date of grant using the Black-Scholes option pricing model with the following
weighted average assumptions; no dividend yield; expected risk free interest
rate of 6.5% for fiscal 1998, 5.0% for fiscal 1999 and 5.5% for fiscal 2000;
expected volatility of 85% for fiscal 1999 and fiscal 2000; and expected life
for the options of five years. The assumptions used to calculate the fair
value of the purchase rights for fiscal 2000 were: no dividend yield; expected
risk free interest rate of 5.5%; expected volatility of 85%; and expected life
of 0.64 years. There were no purchase rights granted in fiscal 1998 or fiscal
1999. The weighted average fair value of stock options and purchase rights
granted under the plans during fiscal 2000 was $11.65 per share for options
granted and $6.49 per share for purchase rights granted. The weighted average
fair value of stock options and purchase rights granted under the plans during
fiscal 1999 was $4.71 per share for options granted and $2.36 per share for
purchase rights granted. The fair value of stock options granted in fiscal
1998 was not material.
(7) Segment Information
The Company has adopted the provisions of SFAS No. 131, Disclosures About
Segments of an Enterprise and Related Information. SFAS No. 131 establishes
standards for the reporting by public business enterprises of information
about operating segments, products and services, geographic areas, and major
customers. The
F-16
<PAGE>
PILOT NETWORK SERVICES, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
method for determining what information to report is based on the way that
management organizes the operating segments within the Company for making
operating decisions and assessing financial performance.
The Company's chief operating decision maker is considered to be the
Company's President and Chief Executive Officer (CEO). The President and CEO
reviews financial information presented on a consolidated basis for purposes
of making operating decisions and assessing financial performance. The
consolidated financial information reviewed by the President and CEO is
prepared on the same basis as information presented in the accompanying
consolidated statement of operations. The Company operates in a single
operating segment: providing comprehensive security services that incorporate
high-bandwidth connectivity and enable secure electronic commerce over the
Internet. No single customer accounted for greater than 10% of revenues in any
period presented and the Company does not have any significant international
operations or export revenues.
(8) Related Party Transactions
In fiscal 2000, Company had $2.0 million in revenue from Primus
Telecommunications Group, Inc. ("Primus"). On March 31, 2000, the Company had
$1.0 million in accounts receivable due from Primus. Primus owns 919,540
shares of the Company's common stock as well as a warrant to purchase 200,000
shares of common stock at a price of $25.00 per share. The chairman and chief
executive officer of Primus is also a member of the Company's board of
directors.
(9) Subsequent Events
In April 2000, the Company received commitments for an additional $4 million
in capital equipment lease lines of credit from two lessors on terms
substantially similar to existing equipment leases.
In June 2000, the Company sold 15,000 shares of convertible preferred stock
directly to an investor at a price of $1,000 per share. The gross proceeds
were $15.0 million. After transaction fees and costs estimated at $1.0
million, the net proceeds to the Company were approximately $14.0 million. At
the investor's option, the convertible preferred stock may be converted into
shares of common stock at the lower of 125% of the average market price
immediately prior to the transaction, specifically $18.266 per share, or 101%
of the average market price immediately prior to conversion. The convertible
preferred stock pays a dividend of 3% per annum which can be paid in cash or
common stock of the Company, at the Company's option. The convertible
preferred stock matures in two years and may be redeemed in either cash or
common stock at the option of the Company. Prior to maturity, the preferred
stock cannot be converted into more than 19.99% of Pilot's outstanding shares
of common stock. This maximum number of shares of common stock upon conversion
includes shares of common stock that may be issued as dividends. At maturity,
the convertible preferred stock may be converted into more than 19.99% of the
Company's outstanding shares of common stock only upon prior approval of the
Company's shareholders. As additional consideration, the Company issued a
warrant to purchase 256,620 shares of common stock at 120% of the average
market price immediately prior to the transaction, specifically $17.536 per
share.
F-17
<PAGE>
PILOT NETWORK SERVICES, INC.
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
(in thousands)
<TABLE>
<CAPTION>
Balance at Balance at
Beginning End
Classification of Year Additions Deductions of Year
-------------- ---------- --------- ---------- ----------
<S> <C> <C> <C> <C>
Allowance for doubtful accounts:
Year ended March 31, 1998......... $ 12 $179 $ (80) $111
Year ended March 31, 1999......... 111 445 (399) 157
Year ended March 31, 2000......... 157 389 (157) 389
</TABLE>
